FINANCIAL PERFORMANCE APPRAISAL

RATIO ANALYSIS

INTRODUCTION
 A Ratio is defined as the indicated quotient of two mathematical expressions and as the relationship between two or more things.  It is a powerful analytical tool useful for measuring performance of an organization.  It helps the management to analyze the past performance of the firm and to make further projections.

DEFINITION
 According to Kennedy and Macmillan, "The relationship of one item to another expressed in simple mathematical form is known as ratio.  According to J. Batty, The term accounting ratio is used to describe significant relationships which exist between figures shown in a balance sheet, in a profit and loss account, in a budgetary control system or in any other part of the accounting organization.

CLASSIFICATION OF RATIOS
The ratio analysis is made of Six broad categories are as follows:

1. Liquidity Ratios

2. Leverage Ratios

3. Asset Management Ratio

4. Profitability Ratios

5. Operating 6. Market Ratios Test Ratios

1. LIQUIDITY RATIOS
 It is also known as Short-term Solvency Ratios.  It measures the company's liquidity & its ability to meet its near-term obligations, and it is a major measure of financial health.  It establishes a relationship between cash and other current assets to current obligations, which provides a quick measure of liquidity.  Also it refers to the ability to pay in cash, the obligations that are due.

(a) Current Ratio ::

 It measures the solvency of the firm in the short term.  A current ratio of 2:1 indicates a highly solvent position.  And 1.33:1 is considered by banks.

Current Ratio = Current Assets Current Liabilities

(a) Current Ratio ::

 Current Assets are those assets which can be converted into cash within a year. It includes cash in hand or at bank, marketable securities, debtors, inventories, bills receivables, prepaid expenses and short term loans & advances.  Current Liabilities and provisions are those which are payable in one year. It includes creditors, bills payable, outstanding expenses and bank overdraft & cash credit.

(b) Quick or Liquid Ratio ::

 It is an improved version of current ratio and also known as Acid Test Ratio.  A quick ratio of 1:1 indicates a highly solvent position.  It is used to measure the companys ability to meet its current obligations.

Quick Ratio = Quick Assets Quick Liabilities

(b) Quick or Liquid Ratio ::

 Liquid Assets are those assets that can be converted into cash quickly, with little or no loss in value. It includes all current assets except inventories and prepaid expenses.  Liquid Liabilities includes all current liabilities except bank overdraft or cash credit.

(c) Absolute Liquid Ratio ::

 Absolute liquid assets includes cash in hand, cash at bank and short term or temporary investments.  The ideal absolute liquid ratio is taken as 1:2.

Absolute Liquid Ratio = Absolute Liquid Assets Current Liabilities

Illustration 1::

2. LEVERAGE RATIO ::
 It is also known as Long Term Solvency Ratios.  These ratios indicate the long term financial prospects of the companys.  The long term stability of the firm may be considered as dependent upon its ability to meet its all liabilities.

(a) Debt Equity Ratio ::

 This ratio indicates the relationship between loan funds and net worth of the company, which is known as 'gearing  If the proportion of debt to equity is low, a company is said to be low-geared, and vice versa.  A debt equity ratio of 2:1 is the norm accepted by financial institutions for financing of projects.

Debt Equity Ratio = Long Term Debt Shareholders Funds

(b) Shareholders Equity Ratio ::

 It is a relationship between the shareholders funds and the total assets.  Shareholders funds represent both equity and preference capital plus reserves and surplus less accumulated losses.

Shareholders Equity Ratio = Shareholders Equity Total Assets (Tangible)

(c) Capital Gearing Ratio ::

Capital Gearing Ratio = Fixed Interest Bearing Funds Equity Shareholders Funds

 The fixed interest bearing funds include debentures, long-term loans and preference share capital.  The equity shareholders funds include equity share capital, reserves and surplus.

(d) Fixed Assets to Long Term Funds Ratio ::

F.Assets to L.T Funds Ratio =

Fixed Assets Long Term Funds

 Fixed assets represents the gross fixed assets minus depreciation.  Long term funds include share capital, reserves and surplus & long term loans.

(e) Proprietary Ratio ::

Proprietary Ratio =

Shareholders Net Worth Total Assets

 Net Worth = Equity share capital + Preference share capital + Reserves Fictitious assets  Total Assets = Fixed assets + Current assets Fictitious assets

(f) Interest Cover ::

Interest Cover = Profit before Interest, Depreciation & Tax Interest

 The interest coverage ratio shows how many times interest charges are covered by funds or (current profits) that are available for the payment of interest.  An interest cover of 2 times is considered reasonable by financial institutions.

(g) Debt Service Coverage Ratio ::

DSCR = Profit after Taxes + Depreciation + Interest on loan Interest on loan + Loan repayment in a year

 It indicates whether the business is earning sufficient profits to pay not only the interest charges, but also the installments due of the principal amount.  This ratio enables the lender to take the correct view of borrowers repayment capacity.

(h) Dividend Cover ::

1) Preference Dividend Cover = Net Profit after Tax Preference Dividend

2) Equity Dividend Cover = Net Profit after Tax Preference Dividend Equity Dividend

Illustration 2 ::

Illustration 3 ::

Illustration 4 ::

3. ASSET MANAGEMENT RATIOS ::

 It is also known as Activity or Turnover Ratios.  It measures how effectively the firm employs its resources.  It involves comparison between the level of sales & investment in various accounts inventories, debtors, fixed assets etc..  These ratios are used to measure the speed with which various accounts are converted into sales or cash.

The following Asset management ratios are calculated for analysis :1) Inventory Turnover Ratio = Cost of Goods Sold Average Inventory Note :: Average Inventory = or Sales Average Inventory

Opening Stock + Closing Stock 2

2) Inventory Ratio = Inventory Current Assets 100

The following Asset management ratios are calculated for analysis :3) Debtors Turnover Ratio = Credit Sales Average Debtors 4) Debtors Collection Period (in days) = Average Debtors Credit Sales 5) Bad Debts to Sales Ratio = Bad Debts Sales 100

365

The following Asset management ratios are calculated for analysis :6) Creditors Turnover Ratio = Credit Purchases Average Creditors 7) Creditors Payment Period (in days) = Average Creditors Credit Purchases 8) Fixed Assets Turnover Ratio = Sales Fixed Assets

365

The following Asset management ratios are calculated for analysis :9) Total Assets Turnover Ratio = Sales Total Assets 10) Working Capital Turnover Ratio = Sales Working Capital 11) Sales to Capital Employed Ratio = Sales Capital Employed

Illustration 5 ::

4. PROFITABILITY RATIOS ::
 There ratios show the combined effects of liquidity, asset management on the results of the companys.  It helps in assessing the adequacy of profits earned by the company & also to discover whether profitability is increasing or declining.  These are measured with the reference to sales, capital employed, total assets employed, shareholders funds etc.

The major Profitability ratios or rates are as follows :1) Gross Profit Margin = Gross Profit 100 Sales Note:: Gross Profit = Sales Cost of Goods Sold 2) Net Profit Margin = Net Profit before Interest & Tax Sales 3) Cash Profit Ratio = Cash Profit Sales 100 100

The major Profitability ratios or rates are as follows :4) Return on Total Assets = Net Profit after Tax Total Assets 100

5) Return on Shareholders Funds or Return on Net Worth = Net Profit after Interest & Tax Net Worth Note :: Net Worth = Equity Capital + Reserves & Surplus 100

Illustration 6 ::

The major Profitability ratios or rates are as follows :-

6) Return on Capital Employed (ROCE) or Return on Investment (ROI) = Net Profit before Interest & Tax 100 Capital Employed

Illustration 7 ::

5. OPERATING RATIOS ::
 The ratios of all operating expenses (i.e. materials used, labor, factory overheads, administration and selling expenses) to sales is the operating ratio.  A comparison of the operating ratio would indicate whether the cost content is high or low in the figure of sales.  The three major components are :: material, labour and overheads.

The classification of Cost ratios are as follows :1) Material Cost Ratio = Material Consumed Sales 2) Labor Cost Ratio = Labor Cost Sales 100 100

3) Factory Overhead Ratio = Factory Expenses Sales 100

The classification of Cost ratios are as follows :4) Administrative Expenses Ratio = Administrative Expenses Sales 5) Selling & Distribution ExpensesRatio = Selling & Distribution Expenses Sales 100

100

6) Operating Ratio = Cost of Goods Sold + Operating Expenses Sales

100

Illustration 8 ::

6. MARKET BASED RATIOS ::

 The market based ratios relates the firm's stock price to its earnings and book value per share.  These ratios give management an indication of what investors think of the company's past performance and future prospects.
1) Earnings Per Share (EPS) = Net Profit after Tax & Preference Dividend Number of Equity Shares 2) Cash Earnings Per Share = Net Profit After Tax + Depreciation Number of Equity Shares

Illustration 9 ::

The remaining Market based ratios are as follows :3) Dividend Payout Ratio = Dividend per Share Earnings per Share 4) Dividend Yield Ratio = Dividend per Share Market Price 100

5) Book Value = Equity Capital + Reserves Profit &Loss A/c Debit Balance Total Number of Equity Share

The remaining Market based ratios are as follows :6) Price Earnings Ratio (P/E Ratio) = Current Market Price of Equity Share Earnings per Share

7) Market Price to Book Value Ratio (P/BV Ratio) = Market Price per Share Book Value per Share

Illustration 10 ::

Illustration 11 ::

Illustration 12 ::

USES OF RATIO ANALYSIS

        To workout the Profitability. To workout the Solvency. Helpful in analysis of financial statement. Helpful in comparative analysis of the performance. To simplify the accounting information. To workout the operating efficiency. To workout short-term financial position. Helpful for forecasting purposes.

LIMITATIONS OF RATIO ANALYSIS

        Limited comparability. False results. Effect of price level changes. Qualitative factors are ignored. Effect of window-dressing. Costly technique. Misleading results. Absence of standard university accepted terminology.