Ratio Analysis

Definition The systematic use of ratios 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. Three types of comparisons are generally involved: Trend analysis Inter-firm comparison Comparison with standards/industry average

S.No.

Ratio

Test for

Indication

Calculation

A. Managements view of Operations 1. Profit ratio

Profit Analysis

r/s b/w gross profit to net sales

Profit before depreciation Net sales

2. Expenses ratio

Control over expenses Contribution to fixed Cost and profit

r/s of expenses items to net sales

r/s b/w contribution to net sales

Various expenses items Net sales

3. P.V. ratio

Net Sales-Variable cost Sales

4. Inventory Ratios (i)Raw materials/stores stock to consumption

Efficiency in inventory management

r/s b/w stocks of raw materials/ stores and average monthly consumption r/s b/w stocks of finished goods and sales per month Selling expenses to sales over a Period Profit per employee over a period

Stocks of raw materials/stores Avg monthly consumption

(ii)Finished goods stock to sales

Efficiency in inventory management

Stocks of finished goods Sales per month

5. Selling expenses ratio Efficiency in selling Expenses 6. Profit per employee Efficiency of employee vis--vis profit

Selling expenses Sales

Profit before depreciation No. of employees

7. Debtors ratio

Efficiency in debt collection

r/s b/w debtors and average daily credit sales r/s of profit before charging interest and income tax to total value of fixed and current assets less current liabilities r/s b/w dividend per share and earning per share

Debtors ______________ Average daily credit sales Profit before interest and depreciation ______________ Capital employed

8. Return on capital employed

How efficiently the capital is employed to earn profits

9. Payout ratio

Managerial ability and Reputation

Dividend per share Earning per share

S.No.

Ratio

Test for How profitably share-holders funds are utilized to earn profits

Indicate r/s b/w shareholders funds and PAT and prefence dividend

Calculations Profit after tax and Preference dividend ________________ Equity share capital

B Owners view point 1. Return on shareholders funds

Price-earnings ratio

Expected return on investment in equity shares

r/s b/w market value of equity share and EPS

Market price per share _____________ EPS

Earnings per share (EPS)

Earning capacity per equity share

PAT and Pref dividend per equity share

Net Profit after Tax and Pref Dividend _______________ No of Equity shares Dividend per share _______________ Market price per share

Yield Ratio

Yield on investment by shareholder at Market Price

r/s b/w dividend per share and market price per share

S. No

Ratio

Test for

Indicate

Calculations

C. Lenders View Point Solvency Ratio

Solvency whether or not a company is heading towards financial disaster

r/s b/w total fixed and current assets and total liabilities not counting shareholders funds

Total Assets Total outside Liabilities

Debt/Equity Ratio

Safety margin for r/s b/w total share holders funds to bankers and lending institutions total borrowings External Equities Internal Equities Efficiency in payments to creditors r/s b/w creditors and average daily credit purchases

Outsiders funds Shareholders funds As long term ratio

Total Long-term Debts Total Long-term Funds (Shareholders funds)

Creditors Ratio

Creditors _______________ Avg daily credit purchases

Current Ratio Acid test Ratio

Classification of Ratios
Classification according to Accounting Statements
Balance Sheet Ratios Profit and Loss Account Ratios Combined Ratios or Inter-statement Ratios

Classification according to Time

Structural Ratios Trend Ratios

Classification according to Importance

Primary Ratios Secondary Ratios

Classification according to Function or Tests

Test of Liquidity Test of Profitability Market tests

Classification according to Nature

Liquidity Ratios Leverage Ratios Turnover or Activity Ratios Profitability Ratios

Ratios

Objectives of analysis (1) 1. Short term financial position or Test of Liquidity

Ratio to be computed (2) 1. Current Ratio

Basic components (3) Current Assets _______________ Current Liabilities Liquidity/Quick Assets ____________________ Current Liabilities Absolute Liquid Assets ____________________ Current Liabilities

2. Quick or Acid Test or Liquid Ratio (for immediate solvency 3. Absolute Liquid Ratio

Balance Sheet of a firm

Liabilities Share Capital Creditors Bills Payable Provision for Tax Amt in Rs 300000 80000 20000 35000 Assets Fixed Assets Cash Book debts Bills Receivables Stock Prepaid Expenses Amt in Rs 165000 10000 60000 20000 175000 5000 _________ 435000 ========

__________ 435000 =========

Comment on the liquidity of the firm

Balance Sheet of ABC Ltd on 31 December

Particulars Stock Debtors Cash at Bank Creditors Bills Payable Provision for Taxes Bank Overdraft 2004 (Rs.) 25000 10000 5000 8000 2000 5000 5000 2005 (Rs.) 40000 16000 4000 15000 3000 7000 15000

Calculate the Current Ratio and Acid Test Ratio for the two years and comment on the liquidity position of the company

Compute Debt-Equity ratio

Particulars Preference Share Capital Equity Share Capital Capital Reserve Profit and Loss Account 6% Debentures Sundry Creditors Bills Payable Provision for Taxation Outstanding creditors Amount in Rs. 300000 1100000 500000 200000 500000 240000 120000 180000 160000

Also calculate Proprietary Ratio (Shareholders Funds / Total Assets or Resources)

Objectives of analysis (1) 2. Current Assets Movement or efficiency of Activity Ratios

Ratio to be computed (2) 1. Inventory/Stock Turnover Ratio

Basic components (3) COGS _______________ Average inventories

2. Debtors or Receivables Turnover Ratio/Velocity

Net sales ______________ Average trade debtors

1.Calculate all significant ratios from the following Balance Sheet and P & L A/c of Aishwarya Ltd
Liabilities
Share capital 2500 shares (ord) @ Rs100 each 6% 500 preference shares @ Rs100 each Reserve funds 6% Debentures Sundry Creditors Bills Payable Provision for Tax Outstanding Expenses Total

Amount Assets
250000 Fixed Assets Investments (Current) 50000 Sundry Debtors Closing stock 200000 Cash 350000 30000 50000 65000 5000 1000000 Total

Amount
650000 75000 100000 150000 25000

_______ 1000000

Profit and Loss A/c for the year ending Dec 31, 2001
Amount Net Sales Less: Cost of Goods Sold (COGS) Gross Profit Less: Operating Expenses Office Selling and Distribution Gross Operating Profit Less: Depreciation Net Operating Profit Add: Other Income Less: Other expenses (Interest) Net Income before Tax Net Income after Tax (50%) Amount 1500000 1290000 210000 34000 11000

45000 165000 50000 115000 7500 122500 21000 101500 50750

2.From the following details prepare Balance Sheet with as many details as possible Stock velocity 6 Capital Turnover Ratio 2 Fixed Assets Turnover Ratio 4 Gross Profit Ratio 20% Debtors velocity 2 months Creditors velocity 73 days

The Gross Profit Rs.60,000. Reserves and Surplus amounts to Rs.20,000. Closing Stock was Rs.5000 in excess of Opening Stock

Balance Sheet Liabilities

Capital Reserves & Surplus Creditors

Amount

Assets

Amount
75,000 42,500 50,000 51,500

150,000 Fixed Assets 20,000 Stock Debtors 49,000 Cash (Balancing fig)

219,000

219,000

3. The following information is given Current Ratio 2.5 Fixed Assets Turnover Ratio 2 times Liquidity Ratio 1.5 Average Debt collection period 2 months Net working capital Rs.300,000 Stock Turnover Ratio 6 times Fixed Assets :Share holders net worth 1:1 Gross Profit Ratio 20% Reserves :Share Capital 0.5:1 Draw up Balance Sheet from the above information

Balance Sheet
Liabilities
Share Capital Reserves Long-term debts Current Liabilities

Amount

Assets

Amount
750,000 300,000 200,000

500,000 Fixed Assets 250,000 Liquid Assets 300,000 Stock 200,000 1250,000

1250,000

4. The info relating to Cosmos Ltd is as given below: Gross Profit Ratio 15% Stock Velocity 6 months Debtors Velocity 3 months Creditors Velocity 3 months Gross profit for the year ending amounts to Rs60000 Closing stock is equal to opening stock Find out: Sales Closing Stock Sundry Debtors Sundry Creditors

5. From the following particulars extracted from the financial statement of Abhishek & Co., compute (a) Current Ratio (b) Liquid Ratio (c) Inventory Turnover Ratio (d) Debtors Turnover Ratio (e) Creditors Turnover Ratio

Particulars
Opening Stock Closing Stock Sales Provision for bad debts Sundry Creditors Loose tools Purchases Sales returns

Rupees
47,000 53,000 255,000 2,000 32,000 4,000 180,000 3,000

Particulars
Sundry Debtors Cash Bank Bills Receivable Provision for Taxation Bills Payable Marketable Securities

Rupees
42,000 10,000 8,000 15,000 15,000 29,000 8,000

Redraft the following financial statements for the purpose of analysis and then compute the following ratios:

Gross Profit Ratio Return on Capital Employed Operating Cost Ratio Net Profit Ratio Current Ratio Liquid Ratio Stock Turnover Ratio Operating Profit Ratio

Trading & Profit and Loss Account

Particulars
To Opening Stock Raw materials Finished goods To Purchases (Raw Materials) To Wages To Factory Exp. To Admn. Exp. To Selling & Dis. To Interest on Deb. To Loss on sale of plant To Net Profit

Rupees Particulars
10,000 20,000 60,000 40,000 20,000 10,000 10,000 2,000 13,000 75,000 260,000 By Sales By Closing Stock Raw materials Finished goods By Profit on sale of shares

Rupees
200,000 30,000 20,000 10,000

260,000

Balance Sheet Liabilities Share Capital Equity Shares@10 Pref. Shares @ 10 Reserves Debentures Creditors Bills Payable Bank Overdraft Rupees Assets Fixed Assets Stock of Materials Raw material Finished Goods Book Debts Cash Rupees 50,000 30,000 20,000 20,000 15,000

20,000 20,000 20,000 40,000 20,000 10,000 5,000 135,000

135,000

Main points to remember

There are many different categories of accounting ratios and many different ratios within each category. Ratios that are of interest to one group of readers of financial statements may not be of interest to another. Ratios may be used in order to review reliability of financial statements. Ratios may be used to review trends between periods for the same company. Ratios may be used to compare a company to others in the same industrial sector. Some ratios are in wide use for which there is no agreed correct formula to calculate them. This makes comparison between analysis reported elsewhere of limited value unless the formula used can be identified.

Main points to remember

The ratios derived can be misleading if taken at face value. It is essential that they are placed in context and that interpretation goes beyond a superficial comparison to general norms. Used casually, accounting ratios can mislead and result in poor quality decision making. Used carefully, accounting ratios can provide pointers towards areas of interest in an entity, and provide a far more complete picture of an entity than that given by the financial statements. Overtrading can be financially disastrous for a business and ratios can be used to help detect it.