RATIO ANALYSIS

Mrs. Dilshad D. Jalnawalla

Accounting ratios are relationships expressed in mathematical terms between figures which are connected with each other in some manner.

Classification of Ratios


Traditional Classification
Trading & Profit & Loss Account Ratios: Ratios: E.g.: Gross Profit Ratio, Stock turnover Ratio, etc. Balance Sheet Ratios: Current Ratio, Ratios: DebtDebt-equity Ratio, etc. Composite Ratios or Inter-statement InterRatios: Ratios: E.g.: Fixed assets turnover ratio, overall profitability ratio, etc.

Functional Classification
In order that ratios serve as a tool for financial analysis, they are classified according to their functions as follows: 1. Profitability Ratios, 2. Turnover Ratios, and 3. Financial Ratios.

Profitability Ratios


Profitability is an indication of the efficiency with which the operations of the business are carried on. Poor Operational performance may indicate poor sales or lack of control over the expenses. Banks, Financial Institutions, Creditors:
Earnings are more than interest on borrowed funds, & ultimate repayment of their debts is certain.

Owners: Returns which they get on investment.

1. Overall Profitability Ratio



Also termed as Return on Investment (ROI) It indicates the percentage of return on the total capital employed in the business. Operating Profit X 100 Capital Employed

Operating Profit means Profit before

Interest and Tax . The term interest means Interest on long-term borrowings long-

Capital Employed:
Sum of all assets whether fixed or current Sum-total of fixed assets SumSum of long term funds employed in the business, i.e. Share Capital+ Reserves and Surplus+ LongLong-term loans- (Non-business Assets+ loans- (NonFictitious Assets)

Illustration 1.2
Particulars
To Cost of goods sold To Interest on Debentures To Provision for Taxation To Net Profit after Tax

P&L Account Rs.

Particulars

Rs.
500000 10000

300000 By Sales By Income from 10000 Investments 100000 100000 510000

510000

Balance Sheet Liabilities

Share Capital: 10% Pref. Equity Reserves 10% Debentures Profit & Loss A/c Provision for Taxation

Rs.
100000 200000 100000 100000 100000 100000 700000

Assets
Fixed Assets Current Assets Investment in Govt. Securities

Rs.
450000 150000 100000

700000

Return on Capital Employed =

Net Operating Profit before Interest and Tax X 100 Total Capital employed = 2,00,000 X 100 5,00,000 = 40% Net Operating Profit =Net Profit + Provision for TaxTax-Income from Investment +Interest on Debentures Capital Employed =Fixed Assets +Current AssetsAssetsProvision for Tax Or Share Capital +Reserves +Debentures +P&L A/c Bal. -Investment in Govt. Securities

i. Return of Shareholders Fund



Net Profit after Interest and Tax X100 Shareholders Fund =1,00,000 X 100 5,00,000 = 20%

ii. Return on Equity Shareholders Funds



Net Profit after Interest , Tax and Preference Dividend X 100 Equity Shareholders Fund

= 90,000 X 100 3,90,000 = 23%

iii. Return on Total Assets

There are three methods: (a) Net Profit after Tax X 100 Total Assets = 1,00,000 X 100 7,00,000 = 14.29%


(b) Net Profit after Tax +Interest Total Assets = 1,00,000+10,000 X 100 7,00,000 = 15.71% (c) Net Profit after Tax + Interest
Total Assets excluding Fictitious Assets

X 100

X 100

iv. Return on Gross Capital employed

Net Profit before Interest and Tax X 100 Gross Capital employed = 2,00,000 X 100 6,00,000 = 33.33%


Interest is on both long and short term borrowings. Gross Capital Employed= Net Fixed Assets +Current Employed= Assets employed in the business.

Average Capital Employed

ROI=Net Profit before Interest and Tax X100 Average Capital employed = 2,00,000 X 100 (5,00,000+4,50,000) = 42.11% Average Capital is Average of Capital employed at the beginning and the end of the accounting period.

Significance of ROI
 

 

ROI is a concept that measures the profit which a firm earns on investing a unit of capital. Profit being net result of all operations, ROI expresses all efficiencies or inefficiencies of a business collectively. It will also show whether company s borrowing policy was wise economically and whether the capital had been employed fruitfully. Equity Shareholders Fund will indicate the maximum rate of dividend that might be declared. The business can survive only when return of capital employed is more than cost of capital employed.

2. Earnings per Share (EPS)

In order to avoid confusion on account of the varied meanings of the term capital employed, the overall profitability can also be judged by calculating EPS. EPS= Net Profit after Tax & Pref. Dividend


Number of Equity Shares

Illustration 1.3
     

Calculate the earnings per share from the following data: Net Profit before Tax Rs.1,00,000 Taxation at 50% of Net Profit 10% Pref. Share Capital (Rs.10 each) Rs.1,00,000 Equity Share Capital (Rs.10 shares) Rs.1,00,000 ANSWER: Rs.4 per share

Significance


The earnings per share helps in determining the market price of the equity share of the company. A comparison of EPS of the company with another will also help in deciding whether the equity share capital is being effectively used or not. It also helps in estimating the companies capacity to pay dividends to its equity holders.

EPS


AS 20

EPS is mandatory w.e.f. 1.4.2001 in respect of enterprises whose equity shares or potential equity shares are listed on recognized stock exchange in India. The standard makes a distinction between basic and diluted earning per share.

Basic Earnings Per Share (BEPS)

Net Profit for the period attributable to Equity Shareholders Weighted Average Number of Equity Shares Outstanding during the year

Illustration 1.4
From the following compute BEPS  Net Profit for the year ending 31.12.2002 after tax & Preference dividend Rs. 21,000.  Equity as on 1.1.2002 Rs.1,800.  Issued Equity Shares for Cash on 31.05.2002 Rs.600  Bought back Equity Shares on 1.11.2002 Rs.300 Answer= Rs. 10 per Share.


Diluted Earnings Per Share (DEPS)



DEPS are calculated when there are potential equity shares in the capital structure of the enterprise. A potential Equity Share is a financial instrument or other contract that entitles or may entitle its holder to equity shares. Adjusted Net Profit for the Period Attributable to Equity Shareholders Adjusted Weighted Average Number of Shares

3. Price Earning Ratio (PER)



This ratio indicates the number of times the earning per share is covered by its market price. Market Price Per Equity Share Earning Per Share The ratio is useful in financial forecasting. It also helps in knowing whether the shares if a company are under or over valued.

Significance of PER


Price Earning Ratio helps the investor in deciding whether to buy or not to buy the shares of a company at a particular market Price.

Gross Profit Ratio



Gross Profit X 100 Net Sales This ratio expresses relationship between gross profit and net sales.

Significance of G.P.Ratio


This ratio indicates the degree to which the selling price of goods per unit may decline without resulting in losses from operations to the firm. Helps in ascertaining whether the average percentage of mark up on the goods is maintained.

Net Profit Ratio



The ratio indicates net margin earned on a sale of Rs.100. Net Operating Profit X 100 Net Sales

Significance


The ratio helps in determining the efficiency with which affairs of the business are being managed. An increase in the ratio over the previous period indicates improvement in the operational efficiency of the business provided the gross profit ratio is constant. Thus it is a effective measure to check the profitability of the business.

Operating Ratio
It is complementary to net profit ratio. If net profit ratio is 20% Operating ratio is 80%  Operating Costs X 100 Net Sales Operating Cost include the cost of direct material, direct labour and other overheads. Interest, provision for taxation etc. are excluded.


Significance


The ratio is the test of the operational efficiency with which the business is being carried. The operating ratio should be low enough to leave a portion of sales to give a fair return to the investors. A comparison of the operating ratio will indicate whether the cost component is high or low in the figure of sales. Increase in ratioratio-should be found out and management should be advised to check the increase.

Fixed Charges Cover

 

 

This Ratio is also called as Debt Service Ratio . This ratio is very important from the lenders point of view. It indicates whether the business would earn sufficient profits to pay periodically the interest charges. The higher the number, the more secure the lender. Income before Interest and Tax Interest Charges Standard is interest charges should be covered 6 to 7 times.

Debt Service Coverage Ratio



The above ratio does not tell us anything about the ability of the company to make payment of principal amount also on time. Net Profit before Income and Tax Principal Payment Installment Interest + I-Tax Rate The principle payment installment is adjusted for tax effects since such payment is not deductible from net profit for tax purpose. The higher the ratio better it is.

Payout Ratio


This ratio indicates what proportion of earning per share has been used for paying dividend. Dividend per equity share Earning per equity share Complementary to this ratio is Retained Earning Ratio Retained Earning per Equity Share OR Earning per Equity Share Retained Earnings X 100 Total Earning

Significance


Payout Ratio and Retained Earning Ratio are indicators of the amount of earnings that have been ploughed back in the business. Lower Payout Ratio, higher earnings ploughed back and vice versa. Lower Retained Earning Ratio, lower amount of Earnings ploughed back and vice versa. Lower Payout Ratio or Higher Retained Earning Ratio means stronger financial position of the business.

Dividend Yield Ratio



This ratio is particularly useful for those investors who are interested only in dividend income. Dividend per share X 100 Market Price per share

Significance


The ratio helps an intending investor in knowing the effective return on the proposed investment. If a company declares dividend at 20% on its shares, each having a paidpaid-up value of Rs.8 and market price of Rs.25, the dividend yield will be only 6.4%. Thus a person can decide whether he wants to invest or not.

TURNOVER RATIOS


The turnover ratios or activity ratios indicate the efficiency with which the capital employed is rotated in the business. Two factors on which overall profitability depends, rate of return of capital employed and the turnover i.e. rate of rotation of capital employed. Higher the rate of rotation, the greater will be the profitability.

Overall profitability ratio can classified as; Net Profit ratio and Turnover ratio. N.P. Ratio= Net Operating Profit X 100 Sales Turnover Ratio =

Sales Capital Employed  Overall Profitability Ratio = Net Profit ratio X Turnover Ratio. = Net Profit Sales 100 X X Sales Capital employed = Net Profit X 100 Capital Employed


Illustration 1.11
Determine which company is more profitable A Ltd. B Ltd. Net Profit Ratio5% Ratio5% 8% Turnover Ratio 6 times 3 times


Fixed Asset Turnover Ratio



This Ratio indicates the extend to which the investments in fixed assets contributed towards sales. It is compared to the previous period it justifies whether investment in fixed asset is judicious or not. Net Sales Fixed Assets (net)

Illustration 1.12
1997= 6,00,000 = 4 times 1,50,000 1998= 3,00,000 = 2.67 times 8,00,000 This shows that there has been a decline in the Fixed Asset Ratio, though sales figures have gone up. It means , increase in the investment in fixed assets has not brought about commensurate gain.

Working Capital Turnover Ratio



The Ratio indicates whether or not working capital has been effectively utilized in making sales. Net Sales Working Capital This ratio can take different forms for different purposes. Some of them are explained:

Debtors Turnover Ratio (Debtors Velocity)



Two Ratios are used by financial analysts to judge the liquidity of a firm Debtors Turnover Ratio and Debt collection period Ratio. Debtors Credit Sales = Turnover Ratio Average Accounts Receivable

Significance


 

Sales to Accounts Receivable Ratio indicates the efficiency of the staff entrusted with collection of book debts. The higher the ratio, the better it is, since it would indicate that debts are being collected more promptly. A standard figure should be set up. The ratio helps in Cash Budgeting since the flow of cash from customers can be worked out on basis of sales.

Debt Collection Period Ratio



The ratio indicates the extent to which the debts have been collected in time. It gives the average debt collection period. The ratio is very helpful for the lenders because it explains to them whether their borrowers are collecting money within a reasonable time. An increase in the period will result in greater blockage of funds in debtors.

a.

Months (or days) in a year Debtors Turnover

Average Accounts Receivable X Months(or days)in a year Credit Sales for the year

b.

c.

Accounts Receivable Average Monthly or Daily Credit Sales

Significance


  

It measures the quality of Debtors since it measures the rapidity or slowness with which money is collected from them. Shorter collection period implies prompt payment. Reduces chances of bad debt Longer collection period implies too liberal and inefficient credit collection. It is difficult to provide a standard collection period for the debtors. In general it should not exceed 3-4 months. 3-

Creditors Turnover Ratio (Creditors Velocity)



It indicates the speed with which the payments for credit purchases are made to the creditors. Credit Purchases Average Accounts Payable Total Purchases Accounts Payable

Debt Payment Period Enjoyed Ratio (Average Age of Payables)

 a.

The ratio gives the average credit period enjoyed from the creditor. Months (or days) in a year Creditors Turnover
Average Accounts Payable X Months (or days) in a year Creditors Turnover

b.

c.

Average Accounts Payable Average Monthly (or daily) credit Purchases

Significance


Both the creditors turnover ratio and the debt payment period enjoyed ratio indicate the promptness or otherwise in making payment of credit purchases. Higher CTR or Lower credit period enjoyed ratio signifies that creditors are being paid promptly.

Stock Turnover Ratio

 

This ratio indicates whether investment in inventory is efficiently used or not. Cost of Goods Sold during the year Average Inventory Average Inventory is calculated by taking stock levels at the end of each month, adding them up and dividing by twelve. This ratio can be calculated for each constituent of inventory.

Significance


It signifies the liquidity of the inventory. A high inventory turnover ratio indicates brisk sales. A low inventory ratio results in blocking of funds in inventory.

FINANCIAL RATIOS


Financial Ratios indicate about the financial position of the company. It is a sound principle of finance that long term requirement of funds should be met out of long term funds and short-term shortshould be met out of short term. Thus the financial position has to be judged from two angles-long-term and short-term. angles-longshort-

Fixed Assets Ratio

  

Fixed Assets LongLong-term Funds The ratio should be more than 1. If less than 1, it shows that a part of the working capital has been financed through long term funds. This is sometimes desirable to some extent because a part of working capital termed as core working capital is more or less of a fixed nature. The ideal ratio is 0.67 Fixed Assets include net fixed assets and trade investments including shares in subsidiaries. Long term funds includes share capital, reserves and long term loans.

Current Ratio
 

This ratio is an indicator of the firms commitment to meet its short term liabilities. Current Assets Current Liabilities Current Assets include cash and other assets convertible or meant to be converted into cash during he operating cycle of the business. Current Liabilities mean liabilities payable within a year s time either out of existing current assets or by creation of new current liabilities. Book debts outstanding for more than 6 months and loose tools should not be included in current assets. Prepaid expenses should be taken.

An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of solvency due to the fact that if the current assets are reduced to half i.e.,1 instead of 2, then also the creditors will be able to get their payments in full. A very high current ratio is also not desirable since it means less efficient use of funds. Because very high ratio means excessive dependence on long term sources of raising funds. Long-term liabilities are Longcostlier than current liabilities and therefore, this will result in considerably lowering down the profitability of the concern.

It is to be noted that mere fact that current ratio is quite high does not mean that the company will be in a position to meet adequately its short term liabilities. In fact the current ration should be seen in relation to the components of the current assets and their liquidity. If a large portion of the current assets comprise obsolete stocks or debtors outstanding for a long time, company may fail if the current ratio is higher than 2.

Significance


The current ratio is an index of the concern s financial stability since it shows the extent of the working capital which is the amount by which the current assets exceed the current liabilities. Higher ratio will indicate inadequate employment of funds and poor ratio is a danger signal to the management.

Liquidity Ratio
 

  

Also termed as Acid Test Ratio or Quick Ratio . Liquid Assets Current Liabilities Prepaid expenses and Stock are not taken in Liquid Assets. The ideal Ratio is 1. The ratio is an indicator of short-term shortsolvency of the company.

A comparison of the current ratio to quick ratio shall indicate the inventory hold-ups. holdFor Example if two units have the same current ratios but different liquidity ratios, it indicates overstocking by the concern having low liquidity ratio as compared to the concern which has higher liquidity ratio.

Debt Equity Ratio



 

This ratio is determined to ascertain the soundness of the long term financial policies of the company. It is also known as External-internal equity Externalratio . External equities Internal equities In case the ratio is 1, it is considered quite satisfactory.

i.

Debt equity Ratio= Total Long Term Debt

ii.

iii.

Total Long-term funds LongDebt equity Ratio= Shareholders funds Total Long term funds Debt equity Ratio= Total Long-term debt LongShareholders funds Ratio (i) & (ii) ideal if they are 0.5 each while ratio (iii) ideal if it is 1. Method (iii) is most popular.

Significance
 

The ratio indicates the proportion of owners stake in the business. Excessive liabilities tend to cause insolvency. The ratio indicates the extent to which the firm depends upon outsiders for its existence. The ratio provides a margin of safety to the creditors. It tells the owner the extent to which they can gain the benefits of maintaining control with a limited investment.

Proprietary Ratio
 

It is a variant of debt-equity ratio. debtIt establishes relationship between the proprietors or shareholders funds and the total tangible assets. Shareholders Funds Total Tangible Assets

Significance


 

The ratio focuses the attention on the general financial strength of the business enterprise. The ratio is of particular importance to the creditors who can find out the proportion of shareholders funds in the total assets employed in the business. High ratio will indicate a relatively little danger to the creditors, in event of forced reorganization or winding up of the company. Low ratio indicates greater risk to the creditors. A ratio below 50% may be alarming for the creditors since they may have to lose heavily in the event of company s liquidation on account of heavy losses.

Advantages of Ratio Analysis

1. 2. 3. 4.

Simplifies Financial Statements Facilitates Inter-firm Comparison InterMakes Intra-firm comparison possible IntraHelps in planning.

Limitations of Accounting Ratios

1. 2. 3. 4. 5. 6.

Comparative study required Limitations of financial statements Ratios alone are not adequate Window dressing Problem of price level changes No fixed standards.