abc ratio analysis

8/8/2019 ABC Ratio Analysis

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Is a method or process by which therelationship of items or groups of items inthe financial statements are computed, andpresented.Is an important tool of financial analysis.Is used to interpret the financial statementsso that the strengths and weaknesses of afirm, its historical performance and current

financial condition can be determined.


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A mathematical yardstick thatmeasures the relationship

between two figures or groupsof figures which are related toeach other and are mutually

inter-dependent.It can be expressed as a pureratio, percentage, or as a rate


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Ratios can be broadly classified into fourgroups namely:Liquidity ratios

Capital structure/leverage ratiosProfitability ratiosActivity ratios


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These ratios analyse the short-termfinancial position of a firm and indicate theability of the firm to meet its short-termcommitments (current liabilities) out of itsshort-term resources (current assets).These are also known as solvency ratios.The ratios which indicate the liquidity of afirm are:Current ratioLiquidity ratio or Quick ratio or acid testratio


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It is calculated by dividing current assets by currentliabilities.Current ratio = Current assets where

Current liabilitiesConventionally a current ratio of 2:1 is considered satisfactory


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include Inventories of raw material, WIP, finished goods,stores and spares,sundry debtors/receivables,

short term loans deposits and advances,cash in hand and bank,prepaid expenses,incomes receivables andmarketable investments and short term securities .


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This is a ratio between quick current assetsand current liabilities (alternatively quickliabilities).

It is calculated by dividing quick current assetsby current liabilities (quick currentliabilities)

Quick ratio = quick assetswhere

Current liabilities/(quickliabilities)

Conventionally a quick ratio of 1:1 isconsidered satisfactory.


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QUICK ASSETS are current assets (as statedearlier)

less prepaid expenses and inventories.

QUICK LIABILITIES are current liabilities (asstated earlier)

less bank overdraft and incomes received inadvance.


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These ratios indicate the long termsolvency of a firm and indicate the abilityof the firm to meet its long-termcommitment with respect to

(i) repayment of principal on maturity or inpredetermined instalments at due datesand

(ii) periodic payment of interest during theperiod of the loan.


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The different ratios are:

Debt equity ratioProprietary ratioDebt to total capital ratioInterest coverage ratioDebt service coverage ratio


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This ratio indicates the relative proportion of debt and equity in financing the assets of thefirm. It is calculated by dividing long-term debtby shareholders funds.Debt equity ratio = long-term debtswhere

Shareholders fundsGenerally, financial institutions favour a ratioof 2:1 .

However this standard should be applied havingregard to size and type and nature of business andthe degree of risk involved.


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LONG-TERM FUNDS are long-term loanswhether secured or unsecured like debentures, bonds, loans from financialinstitutions etc.

SHAREHOLDERS FUNDS are equity sharecapital plus preference share capital plusreserves and surplus minus fictitious assets(eg. Preliminary expenses, pastaccumulated losses, discount on issue of shares etc.)


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This ratio indicates the general financialstrength of the firm and the long- termsolvency of the business.

This ratio is calculated by dividingproprietors funds by total funds.

Proprietary ratio = proprietors fundswhere

Total funds/assets As a rough guide a 65% to 75% proprietary ratio is advisable


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PROPRIETORS FUNDS are same as explainedin shareholders funds

TOTAL FUNDS are all fixed assets and allcurrent assets.Alternatively it can be calculated asproprietors funds plus long-term funds pluscurrent liabilities.


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In this ratio the outside liabilities are relatedto the total capitalisation of the firm. Itindicates what proportion of the permanentcapital of the firm is in the form of long-termdebt.Debt to total capital ratio =long- term debt

Shareholders funds + long-term debtConventionally a ratio of 2/3 is considered satisfactory .


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This ratio measures the debt servicing capacity of a firm in so far as the fixed interest on long-termloan is concerned. It shows how many times theinterest charges are covered by EBIT out of whichthey will be paid.Interest coverage ratio = EBIT

Interest A ratio of 6 to 7 times is considered

satisfactory . Higher the ratio greater the abilityof the firm to pay interest out of its profits. Buttoo high a ratio may imply lesser use of debtand/or very efficient operations


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This is a more comprehensive measure tocompute the debt servicing capacity of a firm. Itshows how many times the total debt serviceobligations consisting of interest and repaymentof principal in instalments are covered by the

total operating funds after payment of tax.Debt service coverage ratio =EAT+ interest + depreciation + other non-

cash expInterest + principal

instalmentEAT is earnings after tax.Generally financial institutions consider 2:1 asa satisfactory ratio .


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These ratios measure the operating efficiency of thefirm and its ability to ensure adequate returns to itsshareholders.The profitability of a firm can be measured by itsprofitability ratios.

Further the profitability ratios can be determined (i)in relation to sales and

(ii) in relation to investments


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Profitability ratios in relation to sales:gross profit marginNet profit margin

Expenses ratio


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Profitability ratios in relation to investmentsReturn on assets (ROA)Return on capital employed (ROCE)

Return on shareholders equity (ROE)Earnings per share (EPS)Dividend per share (DPS)Dividend payout ratio (D/P)

Price earning ratio (P/E)


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This ratio is calculated by dividing gross profit bysales. It is expressed as a percentage.

Gross profit is the result of relationship betweenprices, sales volume and costs.Gross profit margin = gross profit x 100

Net sales


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A firm should have a reasonable gross profitmargin to ensure coverage of its operatingexpenses and ensure adequate return to theowners of the business ie. the shareholders.To judge whether the ratio is satisfactory ornot, it should be compared with the firmspast ratios or with the ratio of similar firmsin the same industry or with the industryaverage.


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This ratio is calculated by dividing net profit by sales.It is expressed as a percentage.This ratio is indicative of the firms ability to leave amargin of reasonable compensation to the owners forproviding capital, after meeting the cost of production, operating charges and the cost of borrowed funds.Net profit margin =

net profit after interest andtax x 100

Net sales


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Another variant of net profit margin isoperating profit margin which is calculated as:Operating profit margin =

net profit before interest and tax x100Net sales

Higher the ratio, greater is the capacity of the

firm to withstand adverse economic conditionsand vice versa


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These ratios are calculated by dividing the variousexpenses by sales. The variants of expenses ratios are:Material consumed ratio = Material consumed x100

Net salesManufacturing expenses ratio = manufacturingexpenses x 100

Net salesAdministration expenses ratio = administration expensesx 100

Net salesSelling expenses ratio = Selling expenses x 100

Net salesOperating ratio = cost of goods sold plus operatingexpenses x 100

Net salesFinancial expense ratio = financial expenses x 100

Net sales


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The expenses ratios should be compared overa period of time with the industry average aswell as with the ratios of firms of similartype. A low expenses ratio is favourable.The implication of a high ratio is that only asmall percentage share of sales is availablefor meeting financial liabilities like interest,tax, dividend etc.


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This ratio measures the profitability of thetotal funds of a firm. It measures therelationship between net profits and totalassets. The objective is to find out how

efficiently the total assets have been used bythe management.Return on assets =

net profit after taxes plusinterest x 100

Total assetsTotal assets exclude fictitious assets. As thetotal assets at the beginning of the year andend of the year may not be the same, averagetotal assets may be used as the denominator.


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This ratio measures the relationship between net profitand capital employed. It indicates how efficiently thelong-term funds of owners and creditors are being used.Return on capital employed =

net profit after taxes plusinterest x 100Capital employed

CAPITAL EMPLOYED denotes shareholders funds and long-term borrowings.To have a fair representation of the capital employed,average capital employed may be used as thedenominator.


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This ratio measures the relationship of profits toowners funds. Shareholders fall into two groups i.e.preference shareholders and equity shareholders. Sothe variants of return on shareholders equity are

Return on total shareholders equity =net profits after taxes x 100Total shareholders equity

.


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TOTAL SHAREHOLDERS EQUITY includespreference share capital plus equity sharecapital plus reserves and surplus lessaccumulated losses and fictitious assets. Tohave a fair representation of the totalshareholders funds, average totalshareholders funds may be used as thedenominator


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Return on ordinary shareholders equity =net profit after taxes pref. dividend x 100

Ordinary shareholders equity or

net worthORDINARY SHAREHOLDERS EQUITY OR NETWORTH includes equity share capital plusreserves and surplus minus fictitious assets.


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This ratio measures the profit available to theequity shareholders on a per share basis. Thisratio is calculated by dividing net profitavailable to equity shareholders by the numberof equity shares.Earnings per share =

net profit after tax preferencedividend

Number of equity shares


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This ratio shows the dividend paid to theshareholder on a per share basis. This is abetter indicator than the EPS as it shows theamount of dividend received by the ordinary

shareholders, while EPS merely showstheoretically how much belongs to the ordinaryshareholdersDividend per share =

Dividend paid to ordinaryshareholdersNumber of equity shares


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This ratio measures the relationship betweenthe earnings belonging to the ordinaryshareholders and the dividend paid to them.Dividend pay out ratio =

total dividend paid to ordinaryshareholders x 100

Net profit after tax preference dividend

ORDividend pay out ratio = Dividend per share x100

Earnings per share


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This ratio is computed by dividing the market price of the shares by the earnings per share. It measures theexpectations of the investors and market appraisal of the performance of the firm.

Price earning ratio = market price per shareEarnings per share


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These ratios are also called efficiency ratios /asset utilization ratios or turnover ratios.These ratios show the relationship betweensales and various assets of a firm. The variousratios under this group are:Inventory/stock turnover ratioDebtors turnover ratio and average collectionperiodAsset turnover ratio

Creditors turnover ratio and average credit period


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This ratio indicates the number of times inventory isreplaced during the year. It measures therelationship between cost of goods sold and theinventory level. There are two approaches forcalculating this ratio, namely:Inventory turnover ratio = cost of goods sold

Average stockAVERAGE STOCK can be calculated as

Opening stock + closingstock

2AlternativelyInventory turnover ratio = sales _________

Closing inventory


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A firm should have neither too high nor toolow inventory turnover ratio. Too high aratio may indicate very low level of inventoryand a danger of being out of stock andincurring high stock out cost. On thecontrary too low a ratio is indicative of excessive inventory entailing excessivecarrying cost.


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This ratio is a test of the liquidity of the debtors of afirm. It shows the relationship between credit salesand debtors.Debtors turnover ratio =

Credit salesAverage Debtors and bills receivables

Average collection period =

Months/days in a yearDebtors turnover


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These ratios are indicative of the efficiencyof the trade credit management. A highturnover ratio and shorter collection periodindicate prompt payment by the debtor. On

the contrary low turnover ratio and longercollection period indicates delayed paymentsby the debtor.In general a high debtor turnover ratioand short collection period is preferable .


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Depending on the different concepts of assets employed,there aremany variants of this ratio. These ratios measure theefficiency of a firm in managing and utilising its assets.Total asset turnover ratio = sales/cost of goods sold

Average total assetsFixed asset turnover ratio = sales/cost of goods sold

Average fixed assetsCapital turnover ratio = sales/cost of goods sold

Average capital employedWorking capital turnover ratio = sales/cost of goods sold

Net working capital


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Higher ratios are indicative of efficientmanagement and utilisation of resourceswhile low ratios are indicative of under-utilisation of resources and presence of idlecapacity.


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This ratio shows the speed with which payments aremade to the suppliers for purchases made from them.It shows the relationship between credit purchases

and average creditors.

Creditors turnover ratio =credit purchasesAverage creditors & bills payables

Average credit period = months/days in a year

Creditors turnover ratio


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Higher creditors turnover ratio and shortcredit period signifies that the creditors arebeing paid promptly and it enhances thecreditworthiness of the firm.


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Financial Ratio AnalysisFinancial Ratio Analysis

Applying analytical techniques to financial statements andother relevant data to produce information useful for decision making.

Three Issues :

Financial analysis:

F o c u s

Profitability, Liquidity, Safety (Solvency or Risk)

In general, each financial ratio is closely related to one of the threefundamental issues.

This analysis is intended as a background review. See also Merrill Lynch Howto Read A Financial Statement which is available on the web.


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Sales $1,800,000

Cost of goods sold (1,000,000)Gross profit 800,000

Operating expenses (486,697)

Interest expenseDepreciation and Amortization expense

(10,000 )(13,303)

Net income before income taxes 290,000

Income taxes (31%) ( 90,000)

Net income after income taxes $ 200,000

Earning per share $2

Operating cash flow $255,000

Dividends for the year $0.80 per share

Market price per share $12

GI CompanyIncome Statement

(Year 1)

Liquidity Ratios


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Liquidity Ratios

Working capital = Current assents Current liabilities

Year 2: $715,000 $695,000 = $20,000

Year 1: $665,000 $700,000 = ($35,000)

Liquidity Ratios


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Liquidity Ratios

Current ratio (working capital ratio) =Current assets

Current liabilities

Year 2: =

Year 1: =

$715,000

$695,000

$665,000

$700,000

= 1.03

= 0.95

(Industry average = 1.5)

The ratio, and therefore Gis ability to meet its short-term obligations, hasimproved, though it is low compared to the industrys average

Liquidity Ratios


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Liquidity Ratios

Acid-test ratio =Cash equivalents + Market securities + Net receivables

Current liabilities

(Year 2) =

(Year 1) =

$50,000 + $75,000 + $300,000

$695,000

$35,000 + $65,000 + $290,000

$700,000

= 1.03

= 0.95

(Industry average = 0.80)

The industry average of .80 is higher than Gis ratio, which indicates that Gimay have trouble meeting short-term needs.


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Activity Ratios


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Activity Ratios

Accounts receivable turnover = Net credit sales

Gross receivables

=

= 6 times

$1,800,000

$300,000

This ratio indicates the receivables quality and indicates the success of the firm incollecting outstanding receivables. Faster turnover gives credibility to the current andacid-test ratios.

Activity Ratios


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y

Accounts receivable turnover in days =Gross receivables

Net credit sales / 365

=

= 60.83days

365 days

Receivable turnover

This ratio indicates the average number of days required to collect accounts receivable.

Activity Ratios


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y

Inventory turnover =Cost of goods sold

Average inventory

=

= 3.45 times

$1,000,000

$290,000

This measure of how quickly inventory is sold is an indicator of enterpriseperformance. The higher of turnover, in general, the better the performance.

Activity Ratios


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Inventory turnover in days =Average inventory

Cost of goods sold / 365

=

=

= 105.80 days

365 days

Inventory turnover 365 days

3.45

This ratio indicates the average number of days required to sell inventory.

y


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Profitability Ratios


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Return on total assets = Net income/Total assets

= $200,000 / $2,615,000

= 7.65%



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Gross margin =

This ratio is a good indication of how profitable a company is at the mostfundamental level. Companies with higher gross margins will have more moneyleft over to spend on other business operations, such as research and developmentor marketing.

Sales Cost of Good Sold

= $1,800,000 - $1,000,000

= $800,000

Gross margin percentage = Gross margin / Sales= $800,000 / $1,800,000

= 44.44%



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Net profit margin = Net income

Net sales

=

= 11.11%

$200,000

$1,800,000

This ratio indicates profit rate and, when used with the asset turnover ratio,indicates rate of return on assets, as show below.



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Operating margin =Operating income

Total sales

Operating margin is a measurement of what proportion of a company's revenue isleft over after paying for variable costs of production such as wages, raw materials,etc. A healthy operating margin is required for a company to be able to pay for itsfixed costs, such as interest on debt.

$800,000 - $486,697

$1,800,000=

= 17.41%

Activity Ratios


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Total asset turnover = Net sales

Total assets

=

= 0.69 times

$1,800,000

$2,615,000

This ratio is an indicator of how Gi makes effective use of its assets. A high ratioindicates effective asset use to generate sales.



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DuPont return on assets = Net income/Total assets

Net income

Net sales

Net sales

Total assetsx=

= 11.11% x 0.69times

= 7.67%

Note that this ratio uses both net profit margin and the total asset turnover. This ratioallows for increased analysis of the changes in the percentages. The net profit marginindicates the percent return on each sale while the asset turnover indicates the effectiveuse of assets in generating that sale.



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Return on investment = Net income + Interest expense (1- Tax rate)

Long-term liabilities + Equity

=

= 0.11 times

$200,000 + $10,000 (1-0.31)

$650,000 + $1,270,000

ROI measures the performance of the firm without regard to the methodof financing.



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Return on common equity = Net income Preferred dividends

common equity

=

= 15.75%

$200,000 - $0

$1,270,000

Long-term Debt-paying Ability Ratio


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(Year 2) = $1,345,000 / $1,270,000 = 1.06

(Year 1) = $1,300,000 / $1,150,000 = 1.13

Debt / Equity =Total liabilities

Common stockholders equity

This ratio indicates the degree of protection to creditors in case of insolvency. Thelower this ratio the better the companys position. In Gis case, the ratio is very high,indicating that a majority of funds come from creditors. However, the ratio isimproving.



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Debt ratio =Total liabilities

Total assets

(Year 2) = $1,345,000 / $2,615,000 = 51.4%

(Year 1) = $1,300,000 / $2,450,000 = 53.1%

This ratio indicates that more than half of the assets are financed by creditors.



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Times interest earned =Returning income before taxes and interest

Interest

=

= 30 times

$290,000 + $10,000

$10,000

This ratio reflects the ability of a company to cover interest charges. It uses incomebefore interest and taxes to reflect the amount of income available to cover interestexpense.



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Operating cash flow / Total debt =Operating cash flow

Total debt

=

= 18.96%

$255,000

$1,345,000

This ratio indicates the ability of the company to cover total debt with yearly cashflow.

Liquidity Ratios


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The operating cash flow ratio = Cash from operations

Current liabilities

$255,000

$700,000

=

= 0.36

The purpose of this ratio is to assess whether or not a company's operations aregenerating enough cash flow to cover its current liabilities. If the ratio falls below 1.00,

then the company is not generating enough cash to meet its current commitments. Note: The cash from operating activities is $255,000 shown at the bottom of theincome statement.

Profitability Ratio


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EBIT

A measure of a company's earning power from ongoing operations, equal toearnings before deduction of interest payments and income taxes. EBIT excludesincome and expenditure from unusual, non-recurring or discontinued activities.

= Earnings + Interest Expense + Tax Expense

= $200,000 + $10,000 + $90,000

= $300,000

Profitability Ratio


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EBITDA

This earnings measure is of particular interest in cases where companies have largeamounts of fixed assets which are subject to heavy depreciation charges or in thecase where a company has a large amount of acquired intangible assets on its booksand is thus subject to large amortization charges . Since the distortionary accountingand financing effects on company earnings do not factor into EBITDA, it is a goodway of comparing companies within and across industries.

= Earnings + Interest Expense + Tax Expense +

Depreciation + Amortization

= $200,000 + $10,000 + $90,000 + $13,303

= $ 313,303

abc ratio analysis

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