31301118 ratio analysis

8/4/2019 31301118 Ratio Analysis

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Meaning of Ratio

According to Accountants Handbook by

Wixon, Kell and Bedford, a ratio is anexpression of the quantitativerelationship between two numbers


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Nature of Ratio Analysis

The ratios may be used as a symptom like blood pressure, thepulse rate or the body temperature and their interpretationdepends upon the caliber and competence of the analyst. Thefollowing are the four steps involved in the ration analysis:

1. Selection of relevant data from the financial statementsdepending upon the objective of the analysis.

2. Calculation of appropriate ratios from the above data.

3. Comparison of the calculated ratios of the same firm in the past,or the ratios developed from projected financial statements or theratios of some other firms or the comparison with the ratios of the

industry to which the firm belongs.4. Interpretation of the ratios.


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Interpretation of the Ratios

The interpretation of ratios is an important factor. Though calculation

of ratios is also important but it is only a clerical task whereas

interpretation needs skill intelligence and foresightedness.

The interpretation of the ratios can be made in the following ways:

1. Single absolute ratio

2. Group of ratios

3. Historical comparison

4. Projected ratios5. Inter-firm comparison


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Guidelines or precautions for use of Ratios

Following guidelines or factors may be kept in mind

while interpreting various ratios:

1. Accuracy of Financial Statements2. Objective or purpose of Analysis

3. Selection of Ratios

4. Use of Standards

5. Calibre of the Analyst

6. Ratios Provide only a base


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Use and Significance of Ratio

Analysis

The ratio analysis is one of the most powerful tools of

financial analysis. It is used as a device to analyze and

interpret the financial health of enterprise. The use of

ratios is not confined to financial managers only. Thesupplier of goods on credit, banks financial institutions,

investors, shareholders and management all make use

of ratio analysis as a tool in evaluating the financial

position and performance of a firm for granting credit,

providing loans or making investments in the firm.


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A. Managerial Uses of Ratio Analysis

1. Helps in decision-making

2. Helps in financial forecasting and planning

3. Helps in communicating

4. Helps in control


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B. Utility to Shareholders/Investors

An investor in the company will like to assess the

financial position of the concern where he is going to

invest. His first interest will be the security of his

investment and then a return in the form of dividend or

interest.


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C. Utility to Creditors

The creditors or suppliers extend short-term credit to the

concern. They are interested to know whether financial

position of the concern warrants their payments at a

specified time or not.


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D. Utility to Employees

The employees are also interested in the financial

position of the concern especially profitability. Their wage

increases and amount of fringe benefits are related to

the volume of profits earned by

the concern.


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Utility to Government

Government may base its future policies on the basis of industrial

information available from various units. The ratios may be used as

indicators of overall financial strength of public as well as private

sector. In the absence of the reliable economic information,

governmental plans and policies may not prove successful.


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Limitations of Ratio Analysis

1. Limited use of a single ratio

2. Lack of adequate standards

3. Inherent limitations of accounting

4. Change of accounting procedure

5. Window dressing6. Personal bias

7. Incomparable

8. Absolute figures distortive

9. Price level changes10. Ratios no substitutes


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Analysis of short term financial position or

test of liquidity

Two types of ratios can be calculated for measuring

short-term financial position or short term solvency of a

firm.

1. Liquidity ratios2. Current assets movement or efficiency ratios


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Liquidity Ratios: Liquidity refers to the ability of a

concern to meet its current obligations as and when

these become due. To measure the liquidity of a firm,

the following ratios can be calculated

:1. Current Ratio2. Quick or Acid Test or Liquid Ratio

3. Absolute Liquid Ratio or Cash Position Ratio


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Current Ratio: Current ration may be defined as the relationship between current

assets and current liabilities. This ratio, also known as working capital ratio.

Thus,

Current Ratio = Current Assets/Current Liabilities

Or Current Assets : Current Liabilities.

Current Assets Current Liabilities

Cash in hand. Outstanding expenses / Accruedexpenses

Cash at bank Bills payable

Marketable securities (short term) Sundry creditors

Short term investment Short term advances

Bills receivable Income tax payable

Sundry debtors Dividends payable

Inventories (stocks) Bank overdraft (if not a permanent arrangement)

Work-in-process

Prepaid expenses


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Interpretation of Current Ratio

A relatively high current ratio is as indication that the firmis liquid and has the ability to pay its current obligationsin time as and when they become due. On the otherhand a relatively low current ration represents that the

liquidity position of the firm not good and the firm shallnot be able to pay its current liabilities in time withoutfacing difficulties. As a convention the minimum of twoto one ratio is referred to as a bankers rule of thumb orarbitrary standard of liquidity for a firm.


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A high current ration may not be favourable due to the

following reasons:

1. There may be slow moving stocks. The stocks will pile

up due to poor sale.2. The figures of debtors may go up because debt

collection is not satisfactory.

3. The cash or bank balances may be lying idle because

of insufficient investment opportunities.


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On the other hand a low current ratio may be to the

following reasons:

1. There may not be sufficient funds to pay off

liabilities.2. The business may be trading beyond its capacity.

The resources may not warrant the activities.


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Important factors for reaching a conclusion

1. Type of Business

2. Types of products

3. Reputation of the concern

4. Seasonal influence

5. Type of assets available

All the above mentioned factors should be taken into mind while

interpreting current ratio.


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Significance and Limitations of Current Ratio

One has to be careful while using current ratio as a measure ofliquidity because it suffers from the following limitations:

1. Crude Ratio

2. Window dressing

a. Over-valuation of closing stockb. Obsolete worthless stocks are shown in the closing inventory at their

cost instead of writing them off.

c. Recording in advance cash receipts applicable to the next years sales.

d. Omission of a liability for merchandise included in inventory.

e. Treating a short term obligation as a long liability.

f. Inadequate provision for bad and doubtful debts.g. Inclusion in debtors advance payment for purchase of fixed assets.


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Quick/Liquid or Acid Test Ratio= Quick or Liquid Assets/Current Liabilities

Quick/Liquid Assets Current Liabilities

Cash in hand Outstanding expenses / Accruedexpenses

Cash at bank Bills payable

Marketable securities Sundry creditors

Temporary investments Short term advances (payable shortly)

Bills receivable Income tax payable

Sundry debtors Dividends payable

Bank overdraft


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Quick assets can also be calculated as:

Current assets (inventories + prepaid expenses).

Investment here will mean all types of stocks i.e.

finished, work-in-process, and raw materials.


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Interpretation of Quick Ratio

Usually, a high acid test ratio is an indication that the firm

is liquid and has the ability to meet its current or liquid

liabilities in time and on the other hand a low quick ration

represents that the firms liquidity position is not good.

As a rule of thumb or as a convention quick ratio of 1:1 is

considered satisfactory.


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Significance of Quick Ratio

It measures the firms capacity to pay off current

obligations immediately and is a more rigorous test of

liquidity than the current ratio. It is used a

complementary ratio to the current ratio.


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Absolute Ratio

Absolute ratio: although receivables, debtors and billsreceivables are generally more liquid than inventories,yet there may be doubts regarding their realization intocash immediately or in time. Hence, some authorities areof the opinion that the absolute liquid ratio should also be

calculated together with current ratio and acid test ratioso as to exclude even receivables from the currentassets and find out the absolute liquid assets.

Absolute Liquid Ratio = Absolute liquid assets/Current Liabilities


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Absolute liquid assets include cash in hand and the bank

and marketable securities or temporary investments.

The acceptable norm for this ratio is 50% or 0.5 : 1 or 1:2

i.e. Rs. 1 worth absolute liquid assets are considered

adequate to pay Rs. 2 worth current liabilities in time as

all the creditors are no expected to demand cash at the

same time and then cash may also be realized from

debtors and inventories.


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Current assets movement or efficiency/activity ratios

Activity ratios measure the efficiency or effectiveness with which a firm

manages its resources or assets. These ratios are also called turnoverratios because they indicate the speed with which assets are converted or

turned over into sales.

Liquidity Ratios Current Assets Movement orEfficiency Ratios

Current ratio Inventory/stock turnover ratio

Quick or acid test or liquid ratio Debtors turnover ratio

Absolute liquid ratio Creditors/payable turnover ratio

Working capital turnover ratio


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Inventory Turnover Ratio (I.T.R.) indicated the number of times thestock has been turned over during the period and evaluates theefficiency with which a firm is able to manage its inventory.

Inventory Turnover Ratio = Cost of goods sold/Average inventory atcost

Inventory Turnover Ratio = Net Sales/Average inventory at cost] Inventory Turnover Ratio = Net Sales/Average inventory at selling

price Inventory Turnover Ratio = Net Sales/Inventory


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Inventory Conversion Period

It may also be interest to see average time taken for

clearing the stocks.

Inventory Conversion Period = Days in a year/Inventory

turnover ratio.


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Interpretation of Inventory Turnover Ratio

Inventory turnover ratio measures the velocity of conversion of stockinto sales. Usually a high inventory turnover/Stock velocity indicatesefficient management of inventory because more frequently thestocks are sold, the lesser amount of money is required to financethe inventory. A very high turnover of inventory does notnecessarily imply higher profits. The profits may be low due to

excessive cot incurred in replacing stocks in small lots, stock-outsituations, selling inventories at very low prices, etc. Hence, incases of too high or too low inventory turnover further investigationshould be made before interpreting the final results. It may also bementioned here that there are no rules of thumb or standardinventory turnover ratio (generally acceptable norms) forinterpreting the inventory turnover ratio. The norms may be differentfor different firms depending upon the nature of industry andbusiness conditions.


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Debtors or Receivable Turnover Ratio and

Average Collection Period

Two kinds of ratios can be computed to evaluate the quality ofdebtors:

Debtors/Receivable turnover or debtors velocity: Debtors turnoverratio indicated the velocity of debt collection of firm. In simplewords, it indicates the number of times average debtors(receivables) are turned over during a year, thus

Debtors (receivables) turnover/velocity = Net credit annualsales/Average trade debtors

= No. of times

Trade debtors = Sundry debtors + Bills receivables and accountsreceivables

Average Trade Debtors = (Opening trade debtors + Closing tradedebtors)/2

Note: Debtors should always be taken at gross value. No provisionfor bad and doubtful debts be deducted from them.


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Interpretation of Debtors Turnover/Velocity

Debtors velocity indicated the number of times the

debtors are turned over during a year. Generally the

higher the value of debtors turnover the more efficient is

the management of debtors/sales or more liquid are the

debtors. But a precaution is needed while interpreting a

very high debtors turnover ratio because a very high

ratio may imply a firms inability due to lack of resources

to sell on credit thereby losing sales and profits. There is

no rule of thumb which may be used as a norm tointerpret the ratio as it may be different from firm to firm,

depending upon the nature of business.


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Average Collection Period Ratio

The average collection period represents the average

number of days for which a firm has to wait before its

receivables are converted into cash.

1. Average Collection Period = Average trade debtors

(Drs + B/R)/Sales per day

2. Sales per day = Net sales/No. of working days.


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Interpretation of Average Collection Period Ratio

Interpretation of Average Collection Period Ratio represents theaverage number of days for which a firm has to wait before itsreceivables are converted into cash. It measures the quality ofdebtors. Generally the shorter the average collection period thebetter is the quality of debtors as a short collection period implies

quick payment by debtors. There is no rule of thumb or standardwhich may be used as a norm which interpreting this ratio as theratio may be different from firm to firm depending upon the creditpolicy, nature of business and business conditions.


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Creditors/Payables Turnover Ratio

In the course of business operations a firm has to make netpurchases and incur short term liabilities. A supplier of goods, i.e.creditor, is naturally interested in finding out how much them the firmis likely to take in repaying its trade creditors.

a) Creditors/Payable Turnover Ratio = Net Credit AnnualPurchases/Average Trade Creditors

b) Average payment period ratio = [Average trade creditors(Creditors + Bills Payable)]/Average daily purchases

Average Daily Purchases = Annual Purchases/No. of working daysin a year

Or Average payment period = Trade creditors x No. of workingdays/Net annual purchases

Or Average payment period = No. of Working Days/Creditorsturnover ratio


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Interpretation of Average Payment Period Ratio

The average payment period ration represents the average numberof days taken by the firm to pay its creditors. Generally lower theration the better is the liquidity position of the firm and higher theratio, less liquid is the position of the firm. But higher paymentperiod also implies greater credit period enjoyed by the firm and

consequently larger the benefit reaped from credit suppliers.


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Working Capital Turnover Ratio

Working capital = Current assets Current Liabilities

Working capital turnover ratio indicates the velocity of the utilization

of net working capital. This ratio indicates the number of times the

working capital is turned over in the course of a year.

Working Capital Turnover Ratio = Cost of sales/Average workingcapital

Average working capital = (Opening working capital + Closing

working capital)/2


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Analysis of Long-Term Financial Position or test of solvency: The

term Solvency refers to ability of a concern to meet its long term

obligations. The following ratios serve the purpose of determining

the solvency of the concern:

1. Debt-Equity Ratio

2. Funded debt to total capitalization ratio

3. Proprietary ratio or equity ratio

4. Solvency ratio or Ratio of total liabilities to total assets

5. Fixed Assets to net worth or proprietors funds ratio

6. Fixed assets to long term funds or fixed assets ratio

7. Ration of current assets to proprietors funds8. debt service ratio or interest coverage ratio

9. Cash to debt-service ratio.


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Debt-Equity Ratio

Debt-Equity ratio also know as External-Internal equity ratio is calculated to

measure the relative claims of outsiders and the owners (i.e., shareholders)against the firms assets.

Debt Equity Ratio = Outsiders Funds/Shareholders Funds

Or Debt to Equity Ratio = External Equities/Internal Equities

The outsiders funds included all debts/liabilities to outsiders, whether long-term or short-term or whether in the form of debentures bonds, mortgagesor bills. The shareholders funds consist of equity share capital preferenceshare capital, capital reserves, revenues reserves and reservesrepresenting accumulated profits and surpluses like reserves for

contingencies sinking fund etc. The accumulated losses and deferredexpenses, if any, should be deducted from the total to find out shareholdersfunds. When the accumulated losses and deferred expenses are deductedfrom the shareholders funds, it is called net worth and the ratio may betermed as debt to net worth ratio.


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Interpretation of Debt-equity Ratio

A ratio of 1 : 1 may be usually considered to be a satisfactory ratioalthough there cannot be any rule of thumb or standard norm for alltypes of businesses. In some business a high ratio 2 : 1 or evenmore may even be considered satisfactory, say, for example in thecase of contractors business. Generally speaking a low ratio (debtbeing low in comparison to shareholders funds) is considered as

favourable from the long-term creditors point of view because ahigh proportion of owners funds provide a larger margin of safety forthem.


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Funded debt to total capitalization ratio

The ratio establishes a link between the long-term funds raised fromoutsiders and total long-term funds available in the business. The twowords used in this ration are (i) Funded Debt and (ii) Total Capitalization

Funded Debt = Debentures + Mortgage loans + Bonds + Other long-termloans

Total Capitalization = Equity Share Capital + Preference Share Capital +

Reserves and Surplus + Other Undistributed Reserves + Debentures +Mortgage Loans + Bonds +Other long-term loans.

Funded debt is that part of Total Capitalization which is financed byoutsiders.

Funded debt to Total Capitalization Ratio = (Funded Debt/TotalCapitalization) x 100

Though there is no rule of thumb but still the lesser the reliance on

outsiders the better it will be. If this ratio is smaller, better it will be up to50% or 55% this ratio may be to tolerable and not beyond.


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Proprietary Ratio or Equity Ratio

A variant to the debt-equity ratio is the proprietary ratio which is also

known as Equity Ratio or Shareholders to Total Equities Ratio or

Net worth to Total Assets Ratio. This ratio establishes the

relationship between shareholders funds to assets of the firm.

Proprietary Ratio or Equity Ratio = Shareholders Funds/Total

Assets


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Interpretation of Equity Ratio

As equity ratio represents the relationship of owners funds to total

assets, higher the ratio or the share of the shareholders in the total

capital of the company better is the long-term solvency position of

the company. This ratio indicated the extent to which the assets of

the company can be lost without affecting the interest of creditors of

the company.


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Solvency ratio or the ratio of total liabilities

to total assets

This ratio is a small variant of equity ratio and can be simply

calculated as 100 equity ratio. The ration indicated the relationship

between the total liabilities to outsiders to total assets of a firm and

can be calculated as follows:

Solvency Ratio = Total Liabilities to Outsiders/Total Assets


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Fixed assets to net worth ratio or ratio of fixed

assets to proprietors funds

The ratio establishes the relationship between fixed

assets and shareholders funds i.e. share capital plus

reserves, surpluses and retained earnings. The ration

can be calculated as follows:

Fixed assets to net worth ratio = Fixed assets (After

depreciation)/Shareholders funds.


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Fixed assets to total long term funds or fixed

asset ratio

A variant to the ratio of fixed assets to net worth is the

ratio of fixed assets to total long-term funds which is

calculated as:


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Calculation of RATIOS

By:

Prof. (Dr.) N.N.Sengupta


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Ratio Components

1. Current Ratio/Working Capital Ratio . Current Assets CurrentLiabilities

2. Liquid Ratio/ Quick Assets Ratio/AcidTest Ratio

Liquid (Quick) AssetsQuick Liabilities

3. Stock to Working Capital Ratio. Stock on HandWorking Capital

4. Proprietary Ratio Proprietors EquityTotal Assets

5. Assets-Proprietorship Ratio Current Assets .Proprietors Equity

Fixed Assets .Proprietors Equity

6. Debt Equity Ratio/Liabilities-Proprietorship Ratio

(a) External LiabilitiesProprietors Equity

(b) Current LiabilitiesProprietors Equity

(c) Long-term LiabilitiesProprietors Equity


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8. Equity capital Ratio Equity Capital and ReservesNet Worth And Debentures

9. Preference Capital Ratio Preference CapitalNet Worth And Debentures

10. Gross Profit Ratio/Margin Ratio/Turnover Ratio

Gross ProfitNet Sales

11. Stock Turnover/Stock Velocity Cost of SalesAvg Stock Carried

12. Net Profit Ratio Net ProfitNet Sales

13. Return on Investment/ ROI Net Profit .Capital Employed

14. Interest Coverage Ratio EBIT .Annual Fixed Interest Charges

15. Dividend Yield Dividend Per Equity Share .Market value Per Equity Share

7. Capital Gearing Ratio Pref. Share Hldr Equity +Debt Hldr EquityOrdinary Shareholders Equity


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A. Solvency and LiquidityPosition(i) Current Ratio

(ii) Liquid Ratio(iii) Stock to working CapitalRatio(iv) Turnover of Debtors(v) Turnover of Creditors, etc.B. profitability Position

(i) Gross Profit Ratio,(ii) Operating Ratio,(iii) Net Profit Ratio,.(iv) ROI(v) Return on Proprietors

Equity,(vi) Return on Ordinary ShareCapital,(vii) Fixed Assets Turnoverand

(viii) Turnover of Total Assets.


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C. Coverage PositionTotal Coverage Ratio=

Where, t= tax rate.

D. Stability Position(i) Proprietary Ratio(ii) Assets Proprietorship Ratio(iii) Debt Equity RatioE. Capital Structure(i) Capital Gearing Ratio(ii) Equity Capital Ratio(iii) Long-term Loan to Net Worth andDebentures, etc.

t-1

TaxesandInterestBeforeProfitNet

PaymentsincipalInterest

Pr+


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F. Measure of Sickness

Profitability Indicators

Sales

Cash operatiosfrom

Worth

CashGenerated

Net

Net

AssetsCurrentGossAssetsFixedGross

+

CashGereratedNet

a)

b)

c)


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Some Questions

for Practice


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Q1. From the following Balance Sheet of Utopia Ltd.,Calculate-a.Current Ratiob.Liquid Ratio

c.Proprietary Ratiod.Debt Equity Ratioe.Gearing Ratio

Balance Sheet Of Utopia Ltd.

LiabilitiesRs.Assets Rs.

Eq. Share Capital50,000

Land & Building90000

Pref. ShareCapital

70,000 Plant &Machinery

155000

Reserves and

Surplus

25,000Stock 100000

6% Debentures1,00,000

Sundry Debtors 60000

Bank Overdraft 80,000 Bills Receivable 10000

Sundry Creditors 70,000 Cash 5000

Bills Pa able 25 000


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Current ratio 2.5

Acid test ratio 1.5

Net Working Capital Rs.3,00,000

Stock turnover ratio 6 times

(Cost of sales toclosing stock )

20%

Gross Profit ratio ----

Average debtcollection period

2 months

Fixed Assets /Shareholders Net

0.80

Q2. Based on the above information you arerequired to prepare the Balance Sheet of theCompany as on 31.12.1992.


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Q3. From the following information of PunjabTraders Ltd. prepare the Statement of Proprietary

Fund of the Company.

(i) Capital Turnover Ratio 2,

(ii) Fixed Assets Turnover Ratio 3,

(iii) Gross Profit Ratio 25 %,

(iv) Stock Velocity 6,(v) Debtors Velocity 4 months, and

(vi) Creditors Velocity 2 months.

The Gross Profit is Rs. 60,000 Reserves and

Surplus are Rs. 20,000. Closing stock is Rs. 6,000

less than the Opening Debtors. Make necessary

assumptions that you think appropriate.


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. From the following particulars prepare a summarized Balancet in details as at 31st December, 2006.

Fixed Assets to NetWorth

0.8:1

Current Ratio 3:1

Reserve included inProprietors Fund

25%

Fixed Assts Rs. 8,00,000

Cash and Bank Balances Rs. 15,000

Current Liabilities Rs. 1,50,000

The firm has no BankOverdraft.


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Q 5. From the following particulars prepare thebalance sheet of the firm concerned:

Stock Velocity 6

Capital turnoverratio

2

Fixed assetsturnover ratio 4

Gross profit ratio 20%

Debt collectionperiod

2 months

Creditors paymentperiod

73 days

The gross profit was Rs. 60,000 Closing stock wasRs. 5,000 in excess of the opening stock

31301118 ratio analysis

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