RATIO ANALYSIS

What are Financial

Statements:

1. Balance Sheet/Position statement

2. Profit and Loss Account/income Statement

3. Statement of Retained Earnings/Profit and Loss

Appropriation Account

4. Cash Flow Statement

Methods of Analyzing

Financial Statements

1. Comparative Statements

2. Common Size Statements

3. Ratio Analysis

4. Cash Flow Statement

Ratio Analysis

• A comparative study of the relationship between various

factors of statements.

• It shows the profitability, liquidity, solvency.

• It helps for forecasting.

• It is helpful for interfirm comparison and intrafirm

comparison.

• These are useful for both internal as well as external

stakeholders.

Classification of Ratios

• 1. Profitability Ratio: It reflects the relationship between

profit and sales, assets or capital employed. It judges the

efficiency of the business.

• 2.Turnover ratio/ Activity Ratio: It measures the

effectiveness of the usage of capital or assets employed in

the business.

• 3. Financial Ratio/solvency Ratio: It judges the

solvency in short term and long term of the company.

• 4. Market Test ratios: It tells the market value of the

company/ shares.

Profitability Ratio1. Return on Investment:

How much company is earning on its investment.

ROI= (Net Operating Profit*100)/ Capital employed

Notes:

• Operating profit is EBIT.

• Non business income should not be included.

• Capital includes share capital, reserve and surplus, long

term loans – non operating assets and fictitious assets.

• It can be net fixed assets + working capital

• ROI= (operating profit/sales) * (sales/capital)

• ROI= net profit ratio * turnover ratio

Numerical 1

• Q. Suppose a company has the following items on the

liabilities side and it shows fictitious asset of Rs. 1,00,000

on the assets side:

13% Preference capital 10,00,000

Equity capital 30,00,000

Reserves 26,00,000

Loans @15% 30,00,000

Current liabilities 15,00,000

Its profit after paying tax @ 50% is Rs. 14,00,000.

Calculate ROI?

SOLUTION

• PBIT= PAT+ TAX+INTEREST ON LOAN

• = 14,00,000+ 14,00,000 + 4,50,000

• = 32,50,000

• Capital employed = 10,00,000+ 30,00,000+

26,00,000+30,00,000-1,00,000= 95,00,000

• ROI= (32,50,000/95,00,000)*100= 34.21%

Profitability ratios

• Return on shareholders’ funds/ return on net worth:

• = (PAT*100)/shareholders' funds

• Capital should be after deducting long term loans.

• It would reflect profitability for the shareholders.

Return on assets:

• It shows whether assets are being properly utilized or not.

• = PAT*100/ Total assets

• Gross profit ratio/gross margin:

• Gross profit is profit before admin, selling and financing expenses.

• =Gross profit*100/sales

• This ratio should be enough high to cover other costs and for proper returns to owners.

• Net profit ratio:

• = operating profit *100/sales

• Net profit= gross profit- admin charges- selling &

distribution charges.

• Non operating incomes and expenses are ignored.

• It shows the expenses for admin and selling are less or

high.

Activity ratio/ turnover ratio• It shows the effectiveness of the resources employed in

business.

• 1) capital turnover ratio:

• = net sales/ capital employed

• Higher the ratio greater the profit.

• 2) total assets turnover ratio:

• = net sales/ total assets

• It can be divided in following parts:

• 2.a.)Fixed assets turnover ratio:

• = net sales/ FA

• FA should be taken after depreciation.

• Working capital turnover ratio:

• = net sales/ working capital

• Stock /inventory turnover ratio:

• = COGS/ avg. inventory

• =sale/avg inventory

• Debtors turnover ratio:

• = net sales/average debtors

• Debtor collection period:

• = (Months or days I a year)/ debtors turnover

• Q. From the following information calculate Debtors

turnover ratio and avg collection period:

• Total debtors opening balance 2,00,000

• Cash sales 1,50,000

• Credit sales 10,00,000

• Cash collected 7,80,000

• Sales return 60,000

• Bad debts 40,000

• Discount allowed 20,000

• Provision for bad debts 20,000

• No of days in a year 360

• Creditors’ turnover ratio:

• = credit purchase/avg creditors

• Debt payment period:

• =( Months or days in a year)/ creditors turnover

Financial ratios/ solvency ratios1. Liquidity ratio: short term solvency ratio

In short term firm should be able to meet all its short term

obligations.

a. Current ratio= current assets/ current liabilities

2:1 is an ideal ratio.

If it is too high it is not a good sign it will effect the

profitability.

b. Quick ratio/ liquid ratio= quick assets/ current

liabilities

Quick assets = current assets – inventory – prepaid

expenses

1:1 is an ideal ratio.

• 2. Long term solvency ratio:

• 2.a. debt-equity ratio:

• External-internal equity ratio

• Debt include debentures, Long term loan from FIs.

• Equity means preference, equity share capital, reserves less loss and fictitious assets as preliminary expenses.

• = Debt/ Equity

• In India 2:1 is ideal.

• It means a company can take debt twice of equity or it can finance 2/3 portion from debt.

• 2.b. Debt service coverage ratio:

• Fixed charges cover/ interest cover ratio.

• It covers the debt servicing capacity of the company.

• = PBT/ Interest charges

• Ideal ration is 6-7.

• 2.c.Capital gearing ratio:

• Proportion of fixed interest or dividend bearing funds and

non fixed interest or dividend bearing funds in total

capital.

• = fixed interest bearing funds/ equity shares funds

Market test ratios

• These are used for the companies whose shares are

trading in the market.

• Following ratios reflect the market value of shares:

• 1. EPS/ earning per share

• EPS= net profit/ no of equity shares

• Net profit should be calculated after preference shares’

dividend.

• It should consider all operating , non operating income

and expenses.

• High EPS, high share price, vice versa.

• 2. Price Earning ratio/ PE Ratio:

it establishes the relation between market price and earning of a share.

= MP of a equity share/ EPS

It helps to decide whether the share is undervalued or overvalued.

3. Pay out ratio:

It shows what is available as earning per share and what is actually paid as dividend out of earnings.

It shows the dividend policy of a company.

= DPS/EPS

4. Dividend yield ratio:

It shows the return shareholders are getting on market price of the shares.

= DPS/ MPS * 100

• From the following information, calculate ( i) Net Assets Turnover (ii) Fixed Assets Turnover and (iii ) Working Capital Turnover Ratios iv) debt- equity ratio v) debtors turnover ratio vi) creditors turnover ratio :

• Preference Shares Capital 4,00,000 Plant and Machinery 8,00,000

• Equity Share Capital 6,00,000 Land and Building 5,00,000

• General Reserve 1,00,000 Motor Car 2,00,000

• Profit and Loss Account 3,00,000 Furniture 1,00,000

• 15% Debentures 2,00,000 Stock 1,80,000

• 14% Loan 2,00,000 Debtors 1,10,000

• Creditors 1,40,000 Bank 80,000

• Bills Payable 50,000 Cash 30,000

• Outstanding Expenses 10,000

• Sales for the year 2005 were Rs. 30,00,000.

• Solution

• Sales = Rs. 30,00,000

• Capital Employed = Share Capital + Reserves and Surplus + Long-term Debt (or Net Assets)

• = (Rs.4,00,000 + Rs.6,00,000) + (Rs.1,00,000 + Rs.3,00,000) + (Rs.2,00,000 + Rs.2,00,000) = Rs. 18,00,000

• Fixed Assets = Rs.8,00,000 + Rs.5,00,000 + Rs.2,00,000 + Rs.1,00,000 = Rs. 16,00,000

• Working Capital = Current Assets – Current Liabilities = Rs.4,00,000 – Rs.2,00,000 = Rs. 2,00,000

• Net Assets Turnover Ratio = Rs.30,00,000/Rs.18,00,000 = 1.67 times

• Fixed Assets Turnover Ratio = Rs.30,00,000/Rs.16,00,000 =

• 1.88 times

• Working Capital Turnover = Rs.30,00,000/Rs.2,00,000 = 15

• times.