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Ch 9 – Ratio Analysis ( Chart 9.1 )
Ratio (^) Formula 1 Current Ratio Current Assets Current Liabilities 2 Quick Ratio (Also called as Liquid Ratio or Acid Test Ratio)
Quick Assets Quick Liabilities
3 Absolute Cash Ratio or Absolute Liquidity Ratio
Cash + Marketable Securities Current liabilities Debt to Total Funds Ratio (or) Debt Ratio
Debt Total Funds
Equity to total Funds Ratio (or) Equity Ratio
Equity Total Funds
Debt – Equity Debt
Ratio (^) Formula
Capital Gearing Ratio
Preference capital + Debt Equity Shareholders Funds
Proprietary Ratio Proprietary Funds Total Assets Debt total Assets Ratio
Debt Funds Total Assets Fixed Asset to Long Term Fund Ratio
Fixed Assets Long Term Funds
Gross Profit Ratio
Gross Profit Sales Operating Profit Ratio
Operating Profit Sales Net Profit Ratio
Net Profit Sales Contribution Sales Ratio or PV Ratio
Contribution Sales
Raw Material Turnover
Cost of Raw Material Consumed Ratio
Average Stock of Raw Material WIP Turnover Ratio
Factory Cost Average Stock of WIP Finished G Stock Turnover Ratio
oods or Cost of Goods SoldAvg. Stock of Finished Goods Debtors Turnover Ratio
Credit Sales Average Accounts Receivable Creditors Turnover Ratio
Credit Purchases Average Accounts Payable Working Turnover Ratio (also called Operating Turnover or Cash Turnover Ratio)
Capital Turnover Net Working Capital
4 5 6 7 8 9
10
11
12
13
14
15
16
17
18
19
20
No. No.
Fixed Assets Turnover Ratio
Turnover (^21) Net Fixed Assets
No. Ratio (^) Formula
Ratio Equity
Ch 9 – Ratio Analysis ( Chart 9.2 )
Term Alternative Term Formula for Computation
a) (^) Debt
Borrowed funds (or) Loan Funds
= Debenture + Long term loans from banks, financial Institutions, etc.
b) Equity
Net worth (or) Shareholders funds (or) Proprietors funds (or) Owners funds (or) Own funds
= Equity Share Capital +Preference Share Capital + Reserves & Surplus – Miscellaneous expenditure (as per balance sheet) – Accumulated losses.
c)
Equity Shareholders Funds
= Equity as above – preference share capital, i.e. = Equity Share Capital + Reserves & Surplus - Miscellaneous expenditure (as per balance sheet)
d) (^) Total Funds
Long Term funds (or) Capital employed (or) Investment
= Debt + Equity (i.e. a + b as above)/.. Liability Route = Fixed !ssets + Net Working Capital//.. !sset Route
020–24466748 / 9011854340 / 9011851796
Item Computation
a) Number of days Average Stock of Raw Materials held 365 Raw Material T/O Ratio b) Number of days Average Stock of WIP held 365 WIP T/O Ratio c) Number of days Average stock of Finished gods held (Or) Number of days sales in inventory or Average stock velocity
365 Finished Goods T/O Ratio
d) Average collection period (of debtors) (or) Number of days sales in Receivable
365 Debtors T/O Ratio e) Average Payment period (of Creditors) (Or) Average payment velocity
365 Creditors T/O Ratio f) Number of days working capital held (also called Operating Cycle or Cash cycle or Working Capital Cycle)
365 Working Capital T/O Ratio
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PROPRIETARY RATIO Proprietary Fund Total Assets
It measures the proportion of total assets financed by shareholders.
COVERAGE RATIOS
DEBT SERVICE COVERAGE RATIO(DSCR)
Earnings available for debt services Interest + Instalments
It measures the ability to meet the commitment of various debt services like interest, installment etc. Ideal Ratio is 2.
INTEREST COVERAGE RATIO
EBIT Interest
It measures the ability of business to meet interest. Ideal Ratio is >1.
PREFERENCE DIVIDEND COVERAGE RATIO
Net Profit/Earnings after taxes(EAT) Preference dividend liability
It measures the ability to pay the preference shareholders dividend.Ideal ratios is >1.
FIXED CHARGES COVERAGE RATIO
EBIT Depreciation Interest+Repayment of loan 1 - tax rate
This ratio shows how many times the cash flow before interest and taxes cover all fixed financing charges. Ideal Ratio is>1.
ACTIVITY RATIO/EFFICIENCY RATIO/PERFORMANCE RATIO/ TURNOVER RATIO
TOTAL ASSET TURNOVER RATIO
Sales/Cost of Goods Sold(COGS) Average Total Assets
A measure of total asset utilisation.It helps to answer the question what sales are generated by each rupee’s worth of assets invested in the business.
FIXED ASSETS TURNOVER RATIO
Sales/Cost of Goods Sold(COGS) Fixed Assets
This ratio is about fixed asset capacity.A reducing sales or profit being generated from each rupee invested in fixed assets may indicate over capacity or poorer performing equipment.
CAPITAL TURNOVER RATIO Sales/(COGS) Net Assets
This indicates the firm's ability to generate sales per rupee of long term investment.
WORKING CAPITAL TURNOVER RATIO
Sales/COGS Working Capital
It measures the efficiency of the firm to use working capital.
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INVENTORY TURNOVER RATIO
COGS/Sales Average Inventory
It measures the efficiency of the firm to manage its inventory.
DEBTORS TURNOVER RATIO
Credit Sales Average Account Receivable
It measures the efficiency at which firm is managing its receivable.
PAYABLES TURNOVER RATIO
Annual Net Credit Purchases Average accounts Payables
It measures the velocity of payables payment.
PROFITABILITY RATIOS BASED ON SALES
GROSS PROFIT RATIO (^) GROSS PROFIT (^) X 100 SALES
This ratio depicts the business ability to control its production cost or to manage the margins it makes on products it buy and sells.
NET PROFIT RATIO (^) NET PROFIT X 100 SALES
It measures the relationship between net profit and sales of the business.
OPERATING PROFIT RATIO (^) OPERATING PROFIT (^) X 100 SALES
It measures operating performance of business.
EXPENSES RATIO
COST OF GOODS SOLD (COGS) RATIO COST OF GOODS SOLD^ X^100 SALES
It measures portion of a particular expenses in
OPERATING RATIO comparison to sales. COGS+OPERATING EXPENSE (^) X (^100) SALES
RATIOS BASED ON RETURN ON ASSET/INVESTMENT
RETURN ON INVESTMENT (ROI) RETURN/PROFIT/EARNINGS INVESTMENT X^100
It measures overall return of the business on investment/equity fund.
RETURN ON ASSETS(ROA) NET PROFIT AFTER TAXES AVERAGE TOTAL ASSETS
It measures net profit per average fixed assets.
RETURN ON CAPITAL EMPLOYED (ROCE)
EBIT* X 100
CAPITAL EMPLOYED *Earning before Interest and Taxes
It measures overall earnings on total capital employed.
RATIO ANALYSIS AND
INTERPRETATION – I
Unit Structure:
4.0 Objectives 4.1 Introduction 4.2 Meaning and Objectives of Ratios 4.2.1 Meaning 4.2.2 Objectives 4.3 Modes of Expressing an Accounting Ratio 4.4 Classification of Ratios 4.4.1 Traditional Classification 4.4.2 Functional Classification of Ratios 4.4.3 Classification from the view point of user 4.5 Balance sheet Ratio 4.5.1 Current Ratio 4.5.2 Liquid Ratio 4.5.3 Proprietary Ratio 4.5.4 Stock-Working Capital Ratio 4.5.5 Capital Gearing Ratio 4.5.6 Debt Equity Ratio 4.6 Revenue Statement Ratio 4.6.1 Gross Profit Ratio 4.6.2 Operating Ratio 4.6.3 Expenses Ratio 4.6.4 Net Profit Ratio 4.6.5 Net Operating Profit Ratio 4.6.6 Stock Turnover Ratio 4.7 Combines Ratio / Composite Ratios 4.7.1 Return on Capital Employed 4.7.2 Return on Proprietors Funds 4.7.3 Return on Equity Share Capital 4.7.4 Earning per Share 4.7.5 Dividend Payout Ratio 4.7.6 Debt Service Ratio 4.7.7 Creditors’ Turnover Ratio 4.7.8 Debtors’ Turnover Ratio 4.8 Limitation of Ratio 4.9 Exercise
4 .0 OBJECTIVES:-
After studying the unit the students will be able to Understand meaning of Ratios. Know the modes of expressing ratios. Know the objectives of ratios analysis. Classify the ratios.
4. 1 INTRODUCTION:-
During the half of the 19th century, the bankers have started using accounting ratios for analyzing credit standing of prospective buyer (debtors). But the ratios analysis of bankers was very much restricted to the study of current ratios only.
In 1919, Alexander was has criticized such restrictions and narrow analysis and pointed out the possible dangers of such analysis. He expressed in his view that in order is get clear picture of financial health of the business enterprise, one has to take into account various other relationships other than current ratios. Then the ratio analysis is considered as strong and efficient tools of analyzing the financial statement.
Ratio analysis is the method or process of expressing relationship between items or group of items in the financial statement are computed, determined and presented. It is an attempt to draw quantitative measures or guides concerning the financial health and profitability of an enterprise. It can be used in trend and static analysis.
It is the process of comparison of one figure or item or group of items with another, which make a ratio, and the appraisal of the ratios to make proper analysis of the strengths and weakness of the operations of an enterprise.
4. 2 MEANING AND OBJECTIVES OF RATIOS:-
4.2.1 Meaning A ratio is one figure expressed in terms of another figure. It is mathematical yardstick of measuring relationship of two figures or items or group of items, which are related, is each other and mutually inter-dependent. It is simply the quotient of two numbers. It can be expressed in fraction or in decimal point or in pure number.
Accounting ratio is an expression relating to two figures or two accounts or two set accounting heads or group of items stated in financial statement.
Example : When current assets of the business enterprise are Rs. 1, 00,000 and current liabilities are Rs. 25,000. The ratio between current assets and current liabilities will be expressed as
OR it is expressed as 4:1.
II) Percentages :- It is expressed as percentage relationship when simple or pure ratio is multiplied by 100.
Example : The current ratio in above example is expressed in percentage by multiplying 4 by 100. i.e. 100 x 4 = 400%
III) Rate :- The ratio is expressed as rates which refer to the ratio over a period of time.
Example : Stock has turned over 8 times a year.
IV) Number of days or week or month :- Certain items of the financial statements are expressed better in the form of days or weeks or months.
Example : Debtors' collection period, credit payment period, movement of stock, etc are expressed in days or weeks or months in a year. If stock turnover ratio is 8 times, they movement of stock is expressed as under : 360 8
45 days, 52 8
6.5 weeks or 12 8
1.5 months
V) Rupees :- In this case numerator is divided by denominator and figure of result is expressed in rupees.
Example : Earnings per share, dividend per share etc are expressed in rupees. It net profit after tax is Rs. 12,500 and number of shares of a company are 1250. Earning per share = NPAT^ 12, No. of shares 1,
Rs.10 per share
Check your progress:
- Define the following terms. a) Percentages c) Rates b) Simple / Pure Ratio d) Ratio
- Explain the objectives of Ratio analysis.
4.4 CLASSIFICATION OF RATIOS: -
The ratios are used for different purposes, for different users and for different analysis.
The ratios can be classified as under: a) Traditional classification b) Functional classification c) Classification from user’s point of view
4.4.1 Traditional classification : As per this classification, the ratios readily suggest through their names, their respective resources. From this point of view, the ratios are classified as follows.
a) Balance Sheet Ratio: - This ratio is also known as financial ratios. The ratios which express relationships between two items or group of items mentioned in the balance sheet at the end of the year. Example: Current ratio, Liquid ratio, Stock to Working Capital ratio, Capital Gearing ratio, Proprietary ratio, etc.
b) Revenue Statement Ratio: - This ratio is also known as income statement ratio which expresses the relationship between two items or two groups of items which are found in the income statement of the year. Example: Gross Profit ratio, Operating ratio, Expenses Ratio, Net Profit ratio, Stock Turnover ratio, Operating Profit ratio.
c) Combined Ratio :- These ratios shows the relationship between two items or two groups of items, of which one is from balance sheet and another from income statement (Trading A/c and Profit & Loss A/c and Balance Sheet). Example : Return on Capital Employed, Return on Proprietors' Fund ratio, Return on Equity Capital ratio, Earning per Share ratio, Debtors' Turnover ratio, Creditors Turnover ratio.
4.4.2 Functional Classification of Ratios : The accounting ratios can also be classified according their functions as follows.
b) Long term creditors: - Normally leverage ratios provide useful information to the long term creditors which include debenture holders, vendors of fixed assets, etc. The creditors interested to know the ability of repayment of principal sum and periodical interest payments as and when they become due.
Example: Debt equity ratio, return on capital employed, proprietary ratio.
c) Short term creditors: - The short-term creditors of the company are basically interested to know the ability of repayment of short-term liabilities as and when they become due. Therefore, the creditors has important place on the liquidity aspects of the company's assets. Example: a) Liquidity Ratios - Current Ratio, Liquid Ratio. b) Debtors Turnover Ratio. c) Stock working capital Ratio.
d) Management: - Management is interested to use borrowed funds to improve the earnings. Example: Return on capital employed, Turnover Ratio, Operating Ratio, Expenses Ratio.
4.5 BALANCE SHEET RATIOS
4.5.1 Current Ratio :
This ratio is also known as Working Capital Ratio. This expresses the relationship between current assets and current liabilities. This ratio is calculated by dividing current assets by current liabilities. It is expressed as pure ratio. Standard current ratio is 2:1. It Means current assets should be double the current liabilities. Current Assets Current Ratio = Current Liabilities
a) Current assets includes I) Inventories of raw materials, finished goods, work-in-progress, stores & spare, loose tools, II) Sundry debtors, III) Short-term loan, deposits, advance, IV) Cash on hand and bank, V) Prepaid expenses, accrued income, VI) Bills receivables, VII) Marketable investments, short term securities.
b) Current liabilities includes sundry creditors, bills payables, outstanding expenses, unclaimed dividends, interest accrued but not due on secured and unsecured loans, advances received, income received in advance, provision for tax, purposed dividend loan installment of secured and unsecured loan payable within 12 months.
c) Significance:
- This ratio tests the credit strength and solvency of an organization.
- It shows strength of working capital,
- It indicates ability to discharge short term liabilities.
4.5.2 Liquid Ratio:
This ratio expresses the relationship between liquid assets and liquid liabilities. This ratio is also known as Quick Ratio or Acid Test Ratio. This ratio is calculated by dividing liquid assets by liquid liabilities. Standard quick ratio is 1:1.
Liquid Ratio = Liquid Assets / Quick Assets Quick or Current Liabilities
a) Liquid assets = Current assets less (Stock, prepaid expenses and advance tax etc)
b) Liquid liabilities = Current liabilities less (Bank overdraft and cash credit etc)
c) Significance :-
- Indicate immediate solvency of enterprise.
- Unlike CR it is more qualitative concept
- As it eliminates inventories, it is rigorous test of liquidity.
- More important for financial institutions.
4.5.3 Proprietary Ratio:
Proprietary ratio is a test of the financial and credit strength of the business. It establishes relationship between proprietors to total assets. This ratio determines the long term solvency of the company.
Alternatively this ratio is also known as Worth Debt Ratio. Net worth to Total Assets Ratio, Equity Ratio, Net Worth Ratio or Assets Backing Ratio, Proprietor's funds to Total Assets Ratio or Share holders Funds to Total Assets Ratio.
This ratio is expressed in percentage.
a) Formula :- Proprietors' or Shareholders' Fund Proprietory Ratio= 100 Total Assets
b) Components:- 1 ) Proprietors Funds = Paid up equity + Reserves and surplus less accumulated loss + paid up preference capital. 2 ) Total assets = Fixed assets + investment + current assets.
a) Formula :-
Capital bearing Fixed Interest or dividend Capital Gearing Ratio= Capital not bearing Fixed Interest or dividend b) Components :- 1 ) Capital bearing fixed interest or dividend comprises of debentures, secured and unsecured loans, and preference share capital. 2 ) Capital not bearing fixed interest or dividend is equity share capital and reserve & surplus.
This ratio also can be expressed in %age by multiplying this ratio by 100.
c) Purpose :- This ratio is used to understand the effective capital structure of the company.
d) Significance :-
- It is mechanism to ascertain the extent to which the company is practicing trade or equity.
- It brings one balanced capital structure.
4.5.6 Debt Equity Ratio :
This ratio express the relationship between external equities and external equities i.e. owners' capital and borrowed capital.
a) Formula :-
Debt equity ratio = Debt^ OR Long Term Debts Equity Shareholders Fund
OR
Long Term Debts Shareholders Funds + Long Term Debts
b) Components :- 1 ) Debts include all liabilities including short term & long term i.e. mortgage loan and debentures. 2 ) Shareholders' funds consist of Preference share capital, Equity share capital, Capital and Revenue Reserves, Surplus, etc.
c) Significance:-
- It shares favorable or non favorable capital structure of the company.
- It shows long term capital structure.
- It reveals high margin of safety to creditors.
- It makes us understand the dependence on long terms debts.
d) Standard: - Standard debt- equity ratio is 2:1. It means debts should be double the shareholders funds.
4.6 REVENUE STATEMENT RATIOS: -
Revenue statement ratios are the ratios which highlights the relation between two items from revenue statements i.e. Trading Account and Profit and Loss Account.
4.6.1 Gross profit ratio : Gross profit ratios express the relationship between gross profit and net sales. This ratio is also known as "Turnover ratio" OR "Margin ratio" OR "Gross margin ratio" OR "Rate of gross profit". This ratio is expressed in percentage of net sales. This ratio says about %age gross profit to net sales.
a) Formula :- Gross Profit Gross Profit Ratio= × 100 Sales
b) Components of this ratio are :-
- Net sales = Total sales less sales return
- Gross profit = Sales - Cost of sales
- Cost of sales = (opening stock + purchases + direct labour + other direct charge) - closing stock
c) Significance:-
- This ratio analyse the basic profitability of business.
- It shows the degree to which the selling price per unit may decline without resulting in loss from operations.
- Yearly comparisons of gross profit ratio reveal the trend of trading results.
4.6.2 Operating Ratio :
This ratio studies the relationship between cost of activities and net sales i.e. cost of goods sold and net sales. This ratio shows the percentage of cost of goods sold with net sales.
a) Formula :-
Operating Ratio = Operating Cost × 100 Net Sales
b) Components: - Operating cost = Cost of goods sold + Other Operating Expenses (administrative expenses, selling & distribution expenses etc.) - Finance Expenses ( income taxes, loss on sale of assets, etc.)
- This ratio enables the income tax department to judge the correctness and reliability of income disclosed in income tax returns.
- Analytical study of this ratio can be judged by trend of expenses.
- Comparative study of year to year expenses can be possible.
4.6.4 Net Profit Ratio:-
Net profit ratio indicates the relationship between net profit and net sales. Net profit can be either operating net profit or net profit after tax or net profit before tax. Alternatively this ratio is also known as "Margin on sales ratio". Normally this ratio is calculated & expressed in percentage.
a) Formula :-
Net profit ratio = Net profit^100 OR NPAT 100 Net sales Net sales
OR NPBT^100 OR ONP 100
Net sales Net sales
b) Significance :-
- It measures overall profitability of business.
- It is very useful in judging return on investments.
- It provides useful inferences as to the efficiency and profitability of business.
- It indicates the portion of net sales is available for proprietors.
- It is clear index of cost control, managerial efficiency, sales promotion, etc.
4.6.5 Net Operating Profit Ratio:
Operating Profit Ratio indicates the relationship between operating profit and net sales. This ratio is expressed in percentage.
a) Formula :-
Net operating profit ratio= Net operating profit 100 Net sales
b) Components:-
- Net Operating Profit = Gross Profit - All Operating Expenses or Sales - Cost Of Goods Sold and Operating Expenses.
- Net sales = Sales - Sales Returns.
c) Significance :-
- It signifies higher operating efficiency of management and control over operating cost.
- It indicates profitability of various operations of the organization i.e. buy, manufacture, sales, etc.
- It shows ability of organization to generate operating profit out of its daily operations.
4.6.6 Stock Turnover Ratio:
Stock turnover ratio shows relationship between costs of goods sold and average stock. This ratio is also known as "Inventory Ratio" or "Inventory Turnover Ratio" or "Stock Turn Ratio" or "Stock Velocity Ratio" or "Velocity of Ratio".
This ratio measures the number of times of stock turns or flows or rotates in an accounting period compared to the sales affected during that period. This ratio indicated the frequency of inventory replacement. This ratio is expressed as rate.
a) Formula :- Cost of goods sold Stock Turnover Ratio = Average stock
b) Components :-
- Cost of goods sold = Sales – Gross Profit
Opening stock + closing stock Average Stock= 2
***** If opening stock is not given, the closing stock is treated as average stock.
c) Alternative method of stock turnover ratio :- This ratio can be calculated by using average stock at selling price at as the denominator. Under this method, average stock at selling price is related to net sales. Stock Turnover Ratio= Net sales Average inventory at selling price
d) Purpose: - Purpose of stock turnover ratio is to
- Calculate the speed at which the stock is being turned over into sales.
- Calculate the stock velocity to indicate the period takes by average stock to be sold out.
- Judge how efficiently the stock are managed and utilised to generate sales.
