Ratio Analysis

Ratio Analysis
Prepared By: Mr. Amit A Rajdev (Faculty of Accounts, VMPIM)
Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.
6-1
Ratio Analysis
Ratio is defined as the relationship between two or more things. things. Standard of Comparison: Comparison: 1. Past Ratios 2. Competitors Ratios 3. Industry Ratios 4. Projected Ratios
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Net Working Capital

Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets.
Table 1: Net Working Capital Particulars Total current assets Total current liabilities NWC Table 2: Change in Net Working Capital Particulars Current assets Current liabilities NWC Company A Rs 1,00,000 25,000 75,000 Company B Rs 2,00,000 1,00,000 1,00,000
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Company A Rs 1,80,000 1,20,000 60,000
Company B Rs 30,000 10,000 20,000
1. Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its short-term obligations.
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1.1 Current Ratio

Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities
Current Ratio =
Particulars Current Assets Current Liabilities Current Ratio
Current Assets Current Liabilities

Firm B Rs 30,000 Rs 10,000 3:1
Firm A Rs 1,80,000 Rs 1,20,000 = 3:2 (1.5:1)
A current ratio of 2:1 indicates highly solvent position.

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1.2 Quick Ratio (Acid-Test )Ratio (AcidThe quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets.
Acid-test Ratio =
Quick Assets Current Liabilities
Quick Assets = Current assets Stock Pre-paid expenses Current Liabilities = Current Liabilities Bank Overdraft
A Quick ratio of 1:1 indicates highly solvent position.
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1.3 Cash Ratio

Since cash is the most liquid asset, a financial analyst may examine cash ratio and its equivalent to current liabilities.
Cash Ratio =
Cash + Market. Securities Current Liabilities
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1.4 Interval Measure

Interval measure relates liquid assets to average daily operating cash outflows.
Interval Measure =
Current Assets - Inventory Avg. Daily Operating Exp.
The daily operating expenses will be equal to cost of goods sold plus selling, administrative and general expenses less depreciation (and other non-cash expenditures) divided by the number of days in the year (360). A Rajdev, Faculty of Accounts, VMPIM. 6-8 Prepared by Mr. Amit
2. Leverage Ratios
6-9
Leverage Capital Structure Ratio

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 . Capital structure or leverage ratios throw light on the long-term solvency of a firm. Accordingly, there are two different types of leverage ratios. First type: These ratios are computed from the balance sheet (a) Total Debt Ratio (b) Proprietary Ratio (c) Debt-equity Ratio (d) Capital Employed to Net Worth Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM. (e) Capital Gearing Ratio Second type: These ratios are computed from the Income Statement (a) Interest coverage Ratio (b) Debt Service Coverage Ratio
6 - 10
2.1 Total Debt Ratio

How much funds are financed by lenders for total assets?
Liabilities
Shareholders Funds - 75 Total Debt - 25 Capital Employed = 100
Debt-equity ratio measures the ratio of longTotal Debt Total Debt ratio de3bt to shareholders equity term or total = Capital Employed
25%
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2.2 Proprietary Ratio

How much funds are financed by Owners for total assets?
Liabilities
Debt-equity ratio measures the ratio of longShareholders Fund Proprietary total de3bt to shareholders equity term or ratio = Capital Employed
75%
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2.2 Proprietary Ratio

Proprietary Ratio or Equity Ratio or Net worth to Total Assets Proprietary ratio indicates the are financed by owners funds. extent to which assets
Proprietary ratio = Proprietary ratio =
Shareholders Net Worth Total assets Owners Equity Total Capital X 100
X 100
As a general rule proprietary ratio of 1 : 2 is considered satisfactory. A ratio below 1 : 2 may be alarming for the creditors since they may loose heavily in case of liquidation of company.
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2.3 Debt-Equity Ratio DebtHow much is the lenders contribution for each rupee owners contribution?
Liabilities
Debt-equity ratio measures the ratio of longTotal Debt Debt-Equity ratio = to shareholders equity term or total de3bt Net worth
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2.3 Debt-equity ratio (Note) DebtDebt-equity ratio measures the ratio of long-term or total debt to shareholders equity.
Debt-equity ratio measures the ratio of long-Financial Institutions + Total Debt Debt-equitytotal de3bt to shareholders equity Public Deposits + Other ratio = term or Shareholders equity Long Term Liabilities
Debentures + Loans from
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.
Note: D/E Ratio

There is another version of debt/equity ratio which takes debt as total debts i.e. short-term debts and shortlonglong-term debts.
Debt-equity ratio measures the ratio of long-term Short-term Debts + Long Term Debts or total de3bt to=shareholders equity Debt-equity ratio
+ Other Current Liabilities

Shareholders equity
This version compares all debts against shareholders equity. Inclusion of short-term debts does not qualify it as solvency ratio. Hence the use of second version of D/E ratio is not recommended unless otherwise stated in the examination problem.
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2.3 Debt-equity ratio (Note) DebtDebt-equity ratio measures the ratio of long-term or total debt to shareholders equity.
Debt-equity ratio measures the ratio of long-term debt + Other Current Total Debt Debt-equitytotal de3bt to shareholders equity Liabilities = Total external ratio = term or Shareholders equity Obligations
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.
Long-term Debt + Short
For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected, its operational flexibility is not jeopardised 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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2.4Capital Employed to Net Worth

Capital Employed to Net Worth Ratio
How much funds are being contributed together by lenders and owners for each rupee of owners contribution?
CE to NW ratio =
Capital Employed Net Worth
X 100
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2.5 Capital Gearing Ratio

Capital Gearing Ratio
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.
Capital Gearing ratio =
Fixed Interest Bearing Funds Equity Shareholders Funds
X 100
Fixed Interest Bearing Funds = Debentures + Long-term loans + Preference Share Capital Equity Shareholders Funds = Equity Share Capital + Reserve & Surplus.
6 - 20
2.5 Interest Coverage

Interest Coverage
Interest coverage ratio indicates how many times the operating profit covers the fixed interest expenses.
Profit Before Interest & Taxes Interest Coverage = Interest on Long-term loans
Fixed Interest Bearing Funds = Debentures + Long-term loans + Preference Share Capital
6 - 21
2.6 Debt Service Coverage Ratio (DSCR)

Interest Coverage
Interest coverage ratio indicates how many times the operating profit covers the fixed interest expenses.
PAT + Depreciation + Interest on Loan Interest on loan + Loan Repayment in a year Profit After Tax but before Interest & Depreciation Interest on loan + Loan Repayment in a year
6 - 22
DSCR =
DSCR =
Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders. Trading on Equity Particular (a) Total assets Financing pattern: Equity capital 15% Debt (b)Operating profit (EBIT) Less: Interest Earnings before taxes Less: Taxes (0.35) Earnings after taxes Return on equity (per cent) A 1,000 1,000 300 300 105 195 19.5 (Amount in Rs thousand) B 1,000 800 200 300 30 270 94.5 175.5 21.9 C 1,000 600 400 300 60 240 84 156 26 D 1,000 200 800 300 120 180 63 117 58.5
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3. Turnover Ratio
The speed at which the assets are converted into sales.
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3.1 Inventory Turnover Ratio

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 or Sales Average inventory
The cost of goods sold = Opening stock + Purchases + Direct Expenses Closing Stock Or COGS = Sales Gross Profit. The average inventory = Opening stock + Closing Stock / 2
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3.2 No. of days Inventory

360 No. of Days Inventory = Inventory Turnover Inventory * 360 No. of Days Inventory = Sales or COGS
The cost of goods sold = Opening stock + Purchases + Direct Expenses Closing Stock Or COGS = Sales Gross Profit. The average inventory = Opening stock + Closing Stock / 2
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3.3 Debtors Turnover Ratio

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
Net credit sales consist of gross credit sales minus returns, if any, from customers. Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year.
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3.4 Collection Period

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 Collection Period Debtors Collection Period
= =
360 Debtors Turnover Avg. Debtors * 360 Net Credit Sales
Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year.
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3.5 Creditors Turnover Ratio

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
Net credit purchases = Gross credit purchases - Returns to suppliers. Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year.
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3.6 Creditors Payment Period

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 Payment Period Creditors Payment Period
360 Creditors Turnover Avg. Creditors * 360 Net Credit Purchases
6 - 30
3.7 Assets Turnover Ratio

Assets turnover indicates the efficiency uses all its assets to generate sales. with which firm Cost of goods sold i. Inventory Turnover measures the activity/liquidity of inventory of i. Total assets turnover = Average is sold a firm; the speed with which inventory total assets ii. Fixed assets turnover = Cost of goods sold Average fixed assets
Cost of goods sold i. Inventory Turnover iii. Capital turnover = measures the activity/liquidity of inventory of Average capital a firm; the speed with which inventory is sold employed iv. Current assets turnover = Cost of goods sold Average current assets
i. Inventorycapital turnover = Costactivity/liquidity of inventory of Turnover measures the of goods sold v. Working Net working capital a firm; the speed with which inventory is sold
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4. Profitability Ratios
Show Profitability of the company.
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Types of Profit
1. Gross Profit 2. Operating Profit 3. Profit Before Interest & Taxes (PBIT) 4. Profit Before Taxes (PBT) 5. Profit After Taxes (PAT) 6. Residual Profit 7. Cash Profit
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1. Gross Profit
The difference between the revenue (Sales) and cost of goods sold is the gross profit. Normally, the profit and loss account is prepared in two parts (1) Trading Account and (2) Profit and Loss Account. Trading Account shows the result of trading operation under normal conditions which represents Gross Profit or Gross Loss.
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2. Operating Profit
It refers to net profit arising from the main revenue producing activities of an enterprise after accounting for operating expenses but before taking into account expenses of financial nature and non-operating income.
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Summary
Sales : Less: Cost of Goods Sold: = Gross Profit (1) Less: Factory Overheads Administrative Overheads Selling & Distribution Overheads Depreciation = Operating Profit
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3. Profit Before Interest & Taxes (PBIT)

It refers to net profit before deducting any amount of financing expenses and income tax. other words when interest expense and tax liability are not accounted for while calculating profit or loss of an enterprise, it is treated as PBIT.
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4. Profit Before Tax (PBT)

When interest expense is subtracted from Profit Before Interest & Tax (PBIT) (or total net earnings) before providing for any income tax thereon, it is called Profit before Tax.
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5. Profit After Tax (PAT)

This refers to net profit after taxes, but before making nay appropriation during the year. The net profit before tax (PBT) is adjusted for tax liability calculated at the current rate of taxation.
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Summarizing All Profits
6 - 40
Sales : Less: Cost of Goods Sold: = Gross Profit - (1) Less: Factory Overheads Administrative Overheads Selling & Distribution Overheads Depreciation = Operating Profit - (2) Add: Other Income = Profit Before Interest & Taxes (PBIT) - (3) Less: Interest = Profit Before Taxes (PBT) - (4) Less: Taxes = Profit After Taxes (PAT) - (5)
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6. Residual Profit
It means the profit which the directors consider, should be distributed among equity shareholders after making necessary adjustments as per the provisions of companies Act.
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7. Cash Profit
When all the non-cash charges which have been debited to Profit and Loss Account are added back to net profit, the amount so arrived at is termed as cash profit. Net Profit Add: Depreciation Discount on issue of share/debentures written off Preliminary expenses written off = Cash Profit
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Profitability Ratio
Profitability Ratios Related to Sales
(i) Gross Profit Margin (ii) Net Profit Margin (iii) Operating Profit (iv) Cash Profit
Profitability Ratios Related to Investments (i) Return on Investments ROCE (ii) Return on Total Assets (iii) Return on Shareholders Equity
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4.1 Gross Profit Margin

Gross 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 Profit X 100 Sales
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4.2 Net Profit Margin

Net Profit Margin
Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted. Net profit margin can be computed in three ways i. Operating Profit Ratio = Earning before interest and taxes Net sales
ii. Pre-tax Profit Ratio =
Earnings before taxes Net sales Earning after interest and taxes Net sales Cash Profit Sales X 100
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iii. Net Profit Ratio = iv. Cash Profit =
4.3 Return on Investment (ROI)

Return on Investments measures the overall effectiveness of management in generating profits with its available assets. i. Return on Capital Employed (ROCE) ROCE = Profit After Tax (PAT) Average total capital employed
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4.4 Return on Total Assets

Return on Total Assets measures profitability of total funds (assets) of a company. It expresses the relationship between net profit and total assets. i. Return on Assets (ROTA) ROA = Profit After Tax Average total assets
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4.5 Return on Shareholders Equity

Return on shareholders equity measures the return on the owners (both preference and equity shareholders) investment in the firm. Return on total shareholders equity = Net profit after taxes Total shareholders equity X 100
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5. MARKET BASED RATIOS

(i) Earnings Per Share (ii) Dividend Per Share (iii) Cash Earnings Per Share (iv) P/E Ratio (v) MV/BV Ratio (i) Dividend Payout Ratio (ii) Retention Ratio (iii) Dividend Yield (iv) Earnings Yield
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5.1 Earnings Per Share (EPS)

EPS is calculated to assess the availability of total profit per share.
Earnings Per Share (EPS) =
Net Profit After Tax & Pref. Div. Average inventory
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5.2 Dividend Per Share (DPS)

DPS measures the dividend available per equity share.
Dividend Per Share (DPS) =
Total Equity Dividend No. of Equity Shares
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5.3 Cash Earnings Per Share

Cash earnings per share measures cash profit per share.
Cash Earnings Per Share =
PAT + Depreciation No. of Equity Shares
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5.4 Dividend Payout Ratio

Dividend Payout Ratio measures the proportionate dividend paid out from total profit available to equity shareholders.
Dividend Payout ratio =
Dividend Per Share Earnings Per Share
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5.5 Retention Ratio

Retention Ratio measures proportionate profit retained in the business.
Retention Ratio = 1 Dividend Payout Ratio
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5.6 Price Earnings (P/E) Ratio

P/E Ratio indicates the number of times the earnings per share is covered by its market price.
Price Earnings (P/E) ratio =
Market Price Per Share (MPS) Earnings Per Share (EPS)
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5.7 Dividend Yield

It expresses the relationship between dividend earned and market price per share.
Dividend Yield =
Dividend Per share Market Price Per Share
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5.8 Earnings Yield

It expresses the relationship between earnings per share and market price per share.
Earnings Per Share (EPS) Earnings Yield = Market Price Per Share (MPS)
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5.9 Market Value to Book Value (MV/BV) Ratio

It expresses the relationship between Market value and book value of equity share.
Market Value to Book Value ratio =
Market Price per Share Book Value per Share
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6. Expenses Ratio
i. Cost of goods sold = ii. Operating expenses = Cost of goods sold Net sales X 100 X 100 Administrative exp. + Selling exp. Net sales Administrative expenses iii. Administrative expenses = Net sales iv. Selling expenses ratio = v. Operating ratio = Selling expenses Net sales X 100
X 100
Cost of goods sold + Operating expenses X 100 Net sales Financial expenses Net sales X 100
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vi. Financial expenses =
1. Important Notes (Debt/Equity Ratio)

1.
Total Debt (TD) = Debentures + Loans from Financial Institutions + Public Deposits + Other Long Term Liabilities. Liabilities. However, another version of Total Debt includes Long-term and short-term Longshortliabilities which is not appropriate for Debt/Equity Ratio. Ratio.
Debt-equity ratio measures the ratio of longTotal Debt ??? Debt-Equity ratio = to shareholders equity term or total de3bt Net worth
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2. Important Notes (Debtors Turnover Ratio)

2.
3.
If in a problem, Credit sales is not given but only sales word is used, consider all sales as Credit Sales. Sales. In the same manner, if opening and closing debtors are not given for calculation of Average debtors, consider all debtors balance as Average Debtors. Debtors.
Debtors turnover ratio = Net credit sales (????) Average debtors (????)
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3. Important Notes (Inventory Turnover Ratio)

4.
4.
Cost of Goods Sold = Opening stock + Purchases + Direct Expenses Closing Stock Or COGS = Sales Gross Profit. Profit.
Inventory turnover ratio = Cost of goods sold or Sales Average inventory
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4. Important Notes (Inventory Turnover Ratio)

4.
It might happen that for Calculation of inventory Turnover Ratio, Cost of Goods sold is not given in a problem nor it is possible to calculate COGS. In this COGS. situation, consider total sales instead of COGS. COGS.
Inventory turnover ratio = Cost of goods sold or Sales Average inventory
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5. Important Notes (Capital Employed)

Share Capital Add: Add: Reserves & Surplus Add: Add: Loans (Secured & Unsecured) Less: Capital-inLess: Capital-in-Progress Investment out-side the business outPreliminary Expenses Debit Balance of P&L A/c = Capital Employed
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Thanku
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Ratio Analysis

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Ratio Analysis

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Ratio Analysis

Prepared By: Mr. Amit A Rajdev (Faculty of Accounts, VMPIM)

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

Net Working Capital

Company A Rs 1,80,000 1,20,000 60,000

Company B Rs 30,000 10,000 20,000

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

1.1 Current Ratio

Current Assets Current Liabilities

Firm A Rs 1,80,000 Rs 1,20,000 = 3:2 (1.5:1)

A current ratio of 2:1 indicates highly solvent position.

Quick Assets Current Liabilities

1.3 Cash Ratio

Cash + Market. Securities Current Liabilities

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

1.4 Interval Measure

Current Assets - Inventory Avg. Daily Operating Exp.

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

Leverage Capital Structure Ratio

2.1 Total Debt Ratio

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

2.2 Proprietary Ratio

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

2.2 Proprietary Ratio

Proprietary ratio = Proprietary ratio =

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

Debentures + Loans from

Note: D/E Ratio

+ Other Current Liabilities

Long-term Debt + Short

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

2.4Capital Employed to Net Worth

Capital Employed Net Worth

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

2.5 Capital Gearing Ratio

Capital Gearing ratio =

Fixed Interest Bearing Funds Equity Shareholders Funds

2.5 Interest Coverage

2.6 Debt Service Coverage Ratio (DSCR)

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

3.1 Inventory Turnover Ratio

Inventory turnover ratio =

Cost of goods sold or Sales Average inventory

3.2 No. of days Inventory

3.3 Debtors Turnover Ratio

Debtors turnover ratio

Net credit sales Average debtors

3.4 Collection Period

Debtors Collection Period Debtors Collection Period

360 Debtors Turnover Avg. Debtors * 360 Net Credit Sales

3.5 Creditors Turnover Ratio

Creditors turnover ratio

Net credit purchases Average creditors

3.6 Creditors Payment Period

Creditors Payment Period Creditors Payment Period

360 Creditors Turnover Avg. Creditors * 360 Net Credit Purchases

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

3.7 Assets Turnover Ratio

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.

Prepared by Mr. Amit A Rajdev, Faculty of Accounts, VMPIM.