ratio analysis - ap

7/31/2019 Ratio Analysis - AP

1/31

1

Ratio AnalysisCompute the standard financial

ratios


2/31

Accounting Ratio

Arithmetical relation between twoaccounting variables, having a cause and

effect relationship

Accounting ratios can be expressed as: Pure or as a quotient

Percentage

Times Fraction

Number of days

2


3/31

Types of Accounting Ratios

Accounting ratios can be classified into

Liquidity or Short-Term Solvency

ratiosActivity or Asset Management Ratios

Financial Structure or Capitalisation

RatiosProfitability Ratios

Market Test Ratios

3


4/31

Liquidity / Solvency Ratios

Measures the firms ability to pay off the

current dues

Current Ratio/Working capital ratio

Quick Ratio/Acid test Ratio

Current Ratio of 2 is ideal

Debtors outstanding for more than 6months not normally considered

Prepaid expenses are treated as current

assets.4


5/31

5

Current assets Current liabilities

Ability to Pay Current Liabilities

Working capital measure of amount of

current asset remaining after all current

liabilities have been paid


6/31

6

Current assets

Current liabilities


Current ratio measures ability to pay

current assets with current liabilities


7/31

ExampleFrom the following compute Current Ratio

Sundry Debtors 100000Prepaid expenses 10000

Cash in hand and bank 30000

Short term investments 20000Machinery 7000

Bills payable 20000

Sundry Creditors 40000Debentures 200000

Stock 40000

Expenses payable 400007


8/31

8

Quick assets

Current liabilities


Quick Ratio (Acid test ratio) if theentity could pay all its current liabilities

if they came due immediately

Quick assets - cash, short-term investments,net current receivables

Exclude stock and prepaid expenses


9/31

Following is the balance sheet of XYZ Limited as

on 31st December, 2002

Liabilities Rs Assets Rs.Equity Share

Capital

24000 Machinery and

equipment

45000

Profit and Loss A/c 6000 Stock 12000

10% Debentures 15000 Sundry Debtors 9000

Sundry Creditors 23400 Cash at Bank 2280

Provision for

taxation

600 Prepaid expenses 720

69000 69000

9


10/31

Activity Ratios

Also termed as Performance or Turnoverratios

Measures the effectiveness with which

the concern uses resources at its disposal Higher the turnover ratio better the use

of resources better profitability ratio

This ratio represents the efficiency ofasset usage to generate sales revenue

10


11/31

11

Cost of goods sold

Average inventory*

Ability to Sell Inventory & Collect

Receivables

Inventory turnover how many times a

year the company sells its average level

of inventory

*Average inventory =

(Beginning inventory + Ending Inventory)/2

Cost of good sold = Sales Gross Profit


12/31

Higher the ratio, indicates more sales are

being produced by a unit of investment in

stocks Purpose : to check if the investment in

stocks is optimal

Industries in which the inventory turnoverratio is high usually work on a

comparatively lower profit margin

Note: Sometimes this ratio is calculated from

sales also


13/31

13

Net credit sales

Average net accounts receivable*

Debtors/Receivables Turnover Ratio

how quickly the company collects cash

from credit customers

*Average net accounts receivable =

(Beginning receivables + Ending receivables)/2

Accounts Receivables includes

Trade Debtors and Bills Receivable


14/31

Important points to note.

Doubtful debts are not deducted from

total debtors

In case details regarding opening and

closing receivables and credit sales is not

given, then the ratio is worked out as

Total sales

Accounts Receivable


15/31

15

Accounts Receivable(Credit Sales for the year/360)

Average Collection Period or Debtor

days

how many days sales remain uncollected

in accounts receivable

The shorter the average collectionperiod, the better the quality of debtors


16/31

Creditors Turnover Ratio

Net credit PurchasesAverage accounts payables*

*Average accounts payable =

(Beginning creditors + Beginning Bills Payable+ Ending receivables + Ending Bills Payable)/2

Accounts Payable

(Credit Purchases/360)

Average Payment Period


17/31

Capital Turnover Ratio

Efficient rotation of capital leads tohigher profitability

Relation between sales and capital

employed

Sales

Capital Employed*

*Capital Employed=

Fixed Assets + Net Working Capital


18/31

Fixed Asset Turnover Ratio

SalesNet Fixed Assets*

*Net Fixed Assets =

Fixed Assets - Depreciation

Working Capital Turnover Ratio

Sales

Net Working Capital


19/31

The following is the Balance Sheet of K Co. Ltd., as on 31st

December 2008

Liabilities Rs. Assets Rs.Share Capital 80000 Fixed Assets 160000

General Reserve 30000 Debtors 60000

Profit & Loss A/c 50000 Bills Receivable 20000

Loan @ 10% 80000 Cash at Bank 50000

Creditors 40000 Preliminary Exps 10000

Bills Payable 20000

300000 300000

Sales during the year amounted to Rs.160,000. Calculate

(a) Capital Turnover Ratio, (b) Fixed Asset Turnover Ratio

and (c ) Working Capital Turnover Ratio


20/31

Capital Turnover Ratio = 160000 = 0.70

230000

Fixed Asset Turnover Ratio = 160,000 = 1

160,000

Working Capital Turnover Ratio

= 160,000 = 2.2970,000


21/31

Financial Structure or

Capitalisation Ratios Debt is a true "double-edged" sword as it

allows for the generation of profits with

the use of other people's (creditors)

money, but creates claims on earningswith a higher priority than those of the

firm's owners

There are two types of Debt Measures

Degree of Indebtedness

Ability to Service Debts


22/31

22

Total liabilities

Total assets

Degree of Indebtedness

Debt ratio proportion of companys

assets financed with debt

Debt Equity Ratio

Ascertains the soundness of the financialpolicies of the company

Debt (Long term loans)

Equity (shareholders funds)


23/31

23

Income from operations*

Interest expense

Ability to Service Debt

Times-interest-earned (interest coverage) how many times operating income covers

interest expense

Debt Service Ratio or Fixed Charges Cover

*Income from operations =

Income before income tax & interest expense


24/31

24

Fixed Asset Ratio

Fixed Assets should be financed onlythrough long term loans

If ratio < 1 means firm has used short

term funds to finance long term assets

Shareholders funds + Long term LoansNet Fixed Assets


25/31

25

Profitability Ratios

Profitability Ratios assess the firm'sability to operate efficiently

Of concern to owners, creditors and

management A Common-Size Income Statement,

which expresses each income

statement item as a percentage ofsales, allows for easy evaluation of the

firms profitability relative to sales


26/31

26

Gross Profit x 100

Net sales

Profitability Ratios

Rate of return on net sales (Gross profitratio

Net Profit Ratio

Net Profit x 100Net sales


27/31

27

Profit before Interest, tax and Dividends

Capital Employed

Overall Profitability Ratios Return on Investment relation between

profit earned and capital employed Measures the earning power of the net assets

in business

Return on Equity profits available to the

equity shareholders

Net ProfitEquity Shareholders funds*

*Equity Shareholders funds =

Paid up capital and reserves


28/31

28

Profitability

Trading on the equity (using leverage)

company borrows at a lower rate then

invests the money to earn a higher rate

A company is favorably leveraged if

return on assets > return on stockholders

equity


29/31

Market Test Ratios

Based on the share market's perception of the

company.

The higher the ratio, the higher the perceived

quality of the earnings by the share market.


30/31

Market Test Ratios

Earnings per share = Net Profit after taxNumber of issued ordinary shares

Dividends per share = Dividends

Number of issued ordinary shares

Dividend payout ratio = Dividends per share *100

Earnings per share

Price Earnings ratio = Market price per share

Earnings per share


31/31

31

Red Flags

Strange movement of sales, inventory,

and receivables

Earnings problems

Decreased cash flow

Too much debt

Inability to collect receivables Inventory buildup

ratio analysis - ap

Documents