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Financial Management

Chapter-4

RATIO ANALYSIS

Ratio expresses important relationship between two related figures of financial statements. Ratio Analysis is an important and widely used tool of financial statement analysis. Ratios primarily helps in identifying the strengths and weakness of a firm. It facilitates the a) Comparison of a firms performance with its competitors. b) Comparison of current years performance of a firm with previous year. c) Comparison of a firms performance with the targets set at the beginning of the period. Types of Ratios 1) Profitability Ratios 2) Liquidity/ Solvency/Stability/Capital Structure Ratios 3) Turnover/Activity/Velocity Ratios 4) Market Test/ Investors Ratios Profitability Ratios : A firms profitability can be measured by calculating these ratios. Some profitability ratios are dependent on sales and some are dependent on the amount invested. a) Profitability ratios dependent on sales 1) Gross Profit Ratio = Gross Profit x 100 Sales

= _______%

2) Net Profit Ratio = Net Profit x 100 = _______% Sales The above two ratio indicates profitability. Higher the ratio means higher profits and vice versa 3) Operating Expenses Ratio = Operating Exp x 100 = _______% Sales Individual Operating Expenses like Office and Administration Exp, Selling and Distribution Exp ratio can also be calculated. 4) Operating Ratio = Cost of Goods Sold + Operating Expenses x 100 = _______% Sales The above ratio indicates how much expenditure is incurred to operate the business as a % Higher the above two ratios means lower profits and vice versa. b) Profitability Ratios dependent on Amount Invested : 1) Return on Capital Employed/Return on Investment (ROCE/ ROI) ROCE / ROI = NPBIT x 100 = _____% Capital Employed The above ratio indicates how much profit the firm is getting by employing the capital in the business. 2) Return on Total Assets (ROTA) ROTA = NPBIT x 100 = _____% Total Assets 3) Return on Shareholder Funds/Networth/Equity (ROE / RONW} ROE / RONW = NPAT _ x 100 = _____% Shareholders Funds The above ratio indicates how much profit the firm is generating for the shareholders. 1

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Financial Management

4) Return on Equity Shareholder funds = NP for Equity Shareholders x 100 = ____% Equity Capital + Reserves - Preliminary Exp The above ratio indicates how much profit the firm is generating for the equity shareholders. 5) Return on Equity Capital = NP for Equity Shareholders x 100 = _____% Equity Capital Liquidity/ Solvency/Stability/Capital Structure Ratios These ratios indicate the solvency position of the firms in the short term and long term. a) Ratios indicating Liquidity and short term solvency position Creditors and short term lenders are usually interested in these ratios as this directly affects them. A satisfactory ratio indicates firms ability to repay them easily whereas an inadequate ratio indicates the firm will face difficulty in payment of its short term liabilties 1) Current ratio = Current Assets = ___: 1 Current Liabilities The above ratio indicates whether the firm is able to repay its short term obligations or not. Generally a Current ratio of 2:1 is considered satisfactory. 2) Liquid ratio = Liquid Assets = ___: 1 Liquid Liabilities Liquid ratio calculates solvency position in a much shorter term than the current ratio. Hence we should not consider those assets which are less liquid and liabilities which are not to be paid in the immediate short term. Therefore generally Liquid Assets = Current assets - Stock - Prepaid Expenses and Liquid Liabilities = Current Liabilities Bank o/d Generally a Liquid ratio of 1:1 is considered satisfactory. 3) Absolute Cash ratio = Cash/Bank + Marketable securities = ____:1 Current Liabilities This ratio indicates immediate solvency position of the firms. Hence it considers only those assets which can be converted into cash immediately. 4) Defence Interval ratio/ = Cash/Bank + Marketable securities = ____ days Cash Interval ratio Daily Operating Expenses (excl non cash items) This ratio indicates the ability of the firm to meet its regular cash operating expenses. b) Ratios indicating Long term solvency and stability position This ratios measures the long term solvency position of the firm. It indicates the mix of owners and borrowed funds and assure the long term lenders with regards to Periodic repayment of Interest Repayment of Loan on maturity There are two types of such ratios 1) Capital structure ratios 2) Coverage ratios Capital Structure ratios 1) Debt / Equity ratio = Long Term borrowed funds = ____:1 2

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Shareholders funds 2) Capital Gearing Ratio = Securities bearing fixed rate of return Securities not bearing fixed rate of return

Financial Management

= Long Term borrowed funds + Preference Capital = ____times Equity shareholders funds Higher the above ratio indicates that the company is highly geared and the profits will fluctuate at a very faster rate in either direction as compared to a firm with a lower ratio. 3) Proprietary ratio = Shareholder funds x 100 = ____% Total Assets Higher the ratio indicates higher stability in the long term and vice versa. Coverage ratios This ratio indicates the firms ability to pay the fixed charges like interest on loans, Preference dividend and repayment of loan installment 1) Interest coverage ratio = NPBIT = ____ times Interest 2) Preference Dividend coverage ratio = NPAT = ____ times Preference Div 3) Debt Interest service coverage ratio = NPBIT + Non cash expenses - Tax = ___ times Interest + Debt installment due for repayment Higher the above ratio gives greater comfort to the lenders and preference shareholders as regards the firms ability for payment of the interest / preference dividend and the repayment of loans.

Turnover/Activity/Velocity ratios These ratios evaluate the efficiency or inefficiency of the firm in utilizing its assets. 1) Capital turnover ratio Sales = ____ times Capital Employed 2) Fixed Assets turnover ratio = Sales = ____ times Fixed Assets Sales = ____ times Total Assets Higher the ratio means higher efficiency in utilizing the assets. 4) Debtors turnover ratio = Credit Sales = ____ times Average Debtors + Bills Receivable Or Debtors Collection period = Average Debtors + Bills Receivable x 12 = ____ months Credit Sales (Note: The above ratio can also be calculated in days and weeks) 3 3) Total Assets turnover ratio = =

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5) Stock turnover ratio = (Finished Goods)

Financial Management

Cost of Goods Sold = ____ times Average Stock of Finished Goods Or Stock holding period = Average stock of Finished Goods x 12 = ____ months Cost of Goods Sold This ratio reflects the speed with which the finished goods are sold. Higher the ratio reflects faster sales/ lesser holding period. 8) Creditors turnover ratio = Credit Purchases = ____ times Average Creditors + Bills Payable Or Creditors Payment period = Average Creditors + Bills Payable x 12 = ____ months Credit Purchases PROBLEMS Q.1. Total Capital of Growfast Co. Ltd. is as follows:10% Preference shares of Rs. 10 each Rs. 50,00,000 Equity shares of Rs. 100 each Rs. 70,00,000 10% Debt Rs. 30,00,000 Additional Information :Profit after tax at 50% Rs. 15,00,000 Depreciation Rs. 6,00,000 Equity Dividend paid 10% Market price per equity share Rs. 200 Calculate the following i. The cover for the preference and equity dividends. ii. The earnings per share. iii. The price earnings ratio. iv. The net funds flow. v. Interest cover ratio and DSCR assuming 20% of debt is repayable in current year. Find out absolute cash ratio & defence interval ratio from the following data; Cash & Bank Balance 10,000 Current Liabilities 20,000 Investments : Marketable 5,000 Non-marketable 7,000 Operating expenses for the year 83,000 (including Rs 10000 depreciation) Both the type of Investments will fetch twice its value if sold today. A company has a profit margin of 20% and asset turnover of 3 times. What is the companys return on investment? How will this return on investment vary if i. profit margin is increased by 5% ii. asset turnover is decreased to 2 times? iii. Profit margin is decreased by 5% and asset turnover is increased to 4 times? From the foll details calculate Basic EPS, Cash EPS and Diluted EPS NPAT Rs. 20 lacs, Pref Div Rs.5 lacs, Dep Rs.3 lacs, number of eq shares 1,00,000 out of which 40,000 equity shares were issued on 1/10/2006 and 20,000 equity shares are issued on 31/12/2006. Year ends on 31/3/2007

Q.2.

Q.3.

Q.4

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Financial Management

Q.5 A company has 2000 equity shares of 100 each, its P/E ratio is 6 times and market capitalization is Rs 9.6 lacs. Company has a policy of 50% dividend payout. Total Assets are of Rs 10 lacs and outside liabilities are Rs 4 lacs. Calculate Dividend Yield ratio EPS Book Value per share Total Dividend Q.6 From the following information ascertain Long term loans, Reserves and Surplus and Capital employed. Capital gearing ratio 0.75 Debt equity ratio 0.40 Equity share capital Rs.3,00,000 Preference Share Capital Rs.1,00,000 From the following particulars prepare the Balance Sheet of M Ltd., Current Ratio 2 Working Capital Rs. 4,00,000 Capital block to current assets 3:2 Fixed assets to turnover 1:3 Sales cash/credit 1:2 Debentures/share capital 1:2 Stock Velocity 2 months Creditors Velocity 2 months Debtors Velocity 2 months Gross profit Ratio 25% (to sales) Capital block includes: P&L 10 % of turnover Reserves 2 % of turnover The following data relates to a company as at 31st March, 2001: Current ratio 1.75 Liquid ratio 1.25 Stock turnover ratio (closing stock) 6 times Gross profit ratio 20% Debt collection period 2 months Reserve to capital ratio 0.6 Fixed assets turnover ratio (on cost of goods sold) 1.2 Capital gearing ratio 0.625 Fixed assets to net worth 1.25 Sales for the year Rs. 15 lakh a) You are required to prepare balance sheet as on 31st March, 2001. b) The company requires working capital finance from bank to augment its operations. As a matter of policy decision, the management has decided that current ratio should not go below 1.5.Calculate the amount of maximum loan which can be availed from the bank.

Q.7.

Q.8

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