Ratio Analysis -1

MMS SEM - 2
Batch– 2010-2011
VESIMSR
Introduction
• Most Widely used technique of financial statement
analysis
• Refers to the numerical / quantitative relationship
between two items/ variables
• Makes related information comparable
• Thus it is quantitative tool enables analysts to draw
quantitative answers to questions
▫ Are net Profits Adequate ?
▫ Are the assets used efficiently ?
▫ Is the firm Solvent ?
▫ Can the firm meet its current obligations and so on ?
Advantages of Ratios in FSA
• 1. It provides precise picture with the help of data.
• 2. It facilitates intra-firm and inter-firm comparisons.
• 3. It assists in trend Analysis.
• 4. It helps in measuring firm's operational efficiency.
• 5. It helps projecting future.
• 6. It helps in predicting corporate sickness and failures.
• 7. Ratios are effective tool for detecting window
dressing.
8. It promotes in setting ideal.
Disadvantages of Ratios in FSA
1. Ratios between unrelated items are meaningless.
2. Problem of setting ideal ratio.
3. Impact of different accounting methods cannot
be reflected through ratios.
4. Ratios are not significant by themselves.
USERS OF FINANCIAL STATEMENTS

• Investors
• Lenders
• Security Analysts
• Managers
• Employees and Trade Unions
• Customers
• Suppliers and Trade Financiers
• Government and Regulatory Authorities
• The Public
Basis of Comparison
• Trend Ratios- measures the direction of change
in performance
• Inter Firm Comparisons- with others in the
same industry/ line of business
• Comparison of items within a single year’s
financial statement of a firm
• Comparison with standards or plans
Types of Ratios
• Liquidity Ratios
• Capital structure/ leverage ratios
• Profitability ratios
• Activity Ratios
Liquidity Ratios
• It measures the ability of a firm to meet its short term
obligations
• Hence proper balance needs to be maintained
between- liquidity and profitability
• Types:
▫ Net working capital
▫ Current ratios
▫ Acid test/ quick ratio
▫ Super quick ratios
▫ Turnover ratios
▫ Defensive- interval ratios
Net Working Capital
• Though not a ratio,
frequently employed
as a measure of a End Year 1 in Rs. End Year 2 in Rs.
company’s liquidity
Current Assets 1,00,000 2,00,000
position
• Does NWC necessarily Current Liabilities 25,000 1,00,000

reflect a change in the NWC 75,000 1,00,000

liquidity position of a
firm?
Current Ratio
• Current Ratio:
Current Assets/ Current Liabilities
Current Assets- In ordinary course of business,
converted into cash within a short period of time,
normally not exceeding one year and includes Cash,
marketable securities, inventory of raw materials,
semi finished (WIP) and finished goods, debtors net
of provision of bad and doubtful debts, bills
receivables and prepaid expenses
Current Ratio
• Current Liabilities: Liabilities which are short term
maturing obligations to be met, within a year,
consists of trade creditors, bills payable, bank
credit, provisions for taxation, dividends payable
and outstanding expense
• As a measure of short term/ current financial
liquidity, it indicates the rupees of current amount
of rupees available per rupee of current liability.
The more is the firm’s ability to meet current
obligations and the greater is the safety of funds of
short term creditors
Current Ratio
• In inter firm
comparison, the firm
with the higher
current ratio has Firm A Firm B

better liquidity/ short Current Assets 1,80,000 Rs. 30,000

Current Liabilities 1,20,000 Rs. 10,000
term solvency
1.5 : 1 3:1
Does a very high current ratio speak good
about the firm?
• It may be an indicative of slack management
practices, as it might signal excessive inventories for
the current requirements and poor credit
management in terms of overextended accounts
receivable
• Conventional Rule: 2:1, however is dependent
on nature of industry
• Do you think the current ratios of public Utility
companies and a wholesaler dealers comparable?
Acid – Test / Quick Ratio
• Current liabilities are fixed, but current assets are subject to
shrinkage in value, for ex: possibility of bad debts, unsaleability
of inventory and so on.
• Some current assets are more liquid than others:
Cash>Receivables>Inventories
Acid –test ratio = Quick assets / Current Liabilities
Quick Assets Includes: 1) Cash and bank balances 2)
short term marketable securities 3) debtors/
receivables
Excludes- Inventory and prepaid expenses
Super quick Assets – Includes only Cash and Marketable
Securities
Turnover Ratios
• Means how quickly certain assets are converted
into cash
• Types-
▫ Inventory Turnover ratio
▫ Debtors Turnover ratio
▫ Creditors turnover ratio
Inventory Turnover Ratio
• Cost of Goods sold / Avg Inventory
• Where COGS = Sales – gross profit
• This ratio indicates how fast inventory is sold.
Higher the ratio, better it is.
• Q1) A firm has sold goods worth Rs.3,00,000/-
with a gross profit margin of 20%. The stock at the
beginning and the end of the year was Rs.
35,000/- and Rs. 45,000/- resp. what is the
inventory turnover ratio? What is the average
holding period of the inventory?

Ans) 6;2 months

Debtors Turnover Ratio
• Net Credit Sales / Avg Debtors
• Where net credit sales is gross credit sales minus
returns, if any from customers
• It measures how rapidly debts are collected. A high
ratio is indicative of shorter time lag between
credit sales and cash collection
• Q2) A firm has made credit sales of Rs. 2,40,000
during the year. The outstanding amount of debt
at the beginning and at the end of the year resp
was Rs. 27,500/- and Rs.32,500/-. Determine the
debtor turnover ratio?

Ans) 8; 1.5 months

Creditors Turnover Ratio
• Net credit purchases/ Avg Creditors
• Where net credit purchases is gross credit purchases
less returns to suppliers
• A low turnover ratio reflects liberal credit terms
granted by suppliers, while a high ratio shows that
accounts are to be settled rapidly. The extent to
which trade creditors are willing to wait for payment
can be approximately by the creditors turnover
ratio.
Summing Up
• Q3) Suppose the firm, in the earlier example 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/- resp. What is the creditors turnover
ratio?
• The combined effect of the three turnover ratios is:
▫ Inventory holding Period
▫ + debtor’s collection period
▫ - Creditor’s payment period
As a rule, the shorter is this period, the better are the
liquidity ratios as measured above and vice versa
Defensive – Interval Ratio
• It measures the ability to meet projected daily expenditure
from operations.
• DIR= Liquid assets (quick)/Projected daily cash requirement
• Proj daily cash Req= Projected cash operating expenditure/
365 days
• The projected cash operating expenditure is based on past
expenditures and future plans. It is COGS excluding non cash
expd- depreciation, plus selling and admin expenditure and
other ordinary cash expenses
• DIR measure the time span a firm can operate on present
liquid assets without resorting to next year’s income