RATIO ANALYSIS

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RATIO ANALYSIS

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Vikash Kumar- 2010237 Pallavi Bhati- 2010214 Fallan Menezes-2010198

What is Ratio Analysis? A tool used to conduct a quantitative analysis of information in a company's financial statements. Why is it used? Ratio Analysis enables to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. It enables analysts to evaluate past performance, assess current financial position, and gain insights for projecting future results.

Category Turnover

Description Measures how efficiently a company performs day-to-day tasks, such as collection of receivables and management of inventory. Measures the company’s ability to meet its short-term obligations. Measures a company’s ability to meet long-term obligations. Measures the company's ability to generate profitable sales from its resources(assets).

Liquidity Solvency Profitability

Liquidity Ratios Current Ratio Quick Ratio (Acid Test Ratio)

Turnover Ratios Inventory Turnover Ratio Debtor Turnover Ratio Asset Turnover Ratio

Solvency Ratios Debt Equity Ratio Interest Coverage ratio

Profitability Ratios Gross Profit Ratio Net Profit Ratio

Cash Ratio

Operating ratio

Expense Ratio
Return on Capital Employed Return on Shareholder’s Funds



Liquidity is the ability of a firm to meet its current liabilities. It is of great importance to creditors. Eg- Current Ratio, Quick Ratio, Cash Ratio. Current Assets are the assets which can be converted into cash within a period of one year. It includes cash in hand, cash in bank, Accounts Receivable, Inventory, Prepaid Expenses, Marketable Securities, Short term investments. Current Liabilities are liabilities which are due to be paid by the company within a period of one year. It includes Accounts payable, Short term loans.

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Net Working Capital = Current Assets – Current Liabilities

Current Ratio = Current Assets/Current Liabilities
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Indicates a firm’s ability to meet its short term liabilities on time Current Assets= Rs 40000 & Current Liabilities =Rs.20,000 Current Ratio will be : Rs.40,000/Rs.20,000 = 2 : 1 The ideal current ratio is 2:1 i.e. Current Assets should be at least twice of its current liabilities. Although the ideal ration varies from industry to industry If current ratio is less than 2:1, it indicates lack of liquidity and shortage of working capital If current ratio is higher than 2:1, then stock might be piling up, large amount in debtors due to inefficient debt collection policy & cash laying idle due to poor inadequate investments

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities
Quick Current Assets= Current assets – stock- prepaid expenses.


 



Indicates whether the firm is in a position to pay its current liabilities within a month or immediately Ideal quick ratio is said to be 1:1 The quick ratio is a more conservative and realistic than current ratio because it includes only the more liquid assets Better test of short term financial position of a firm than the current ratio.

Cash Ratio= Cash+ Cash equivalents/Current Liabilities
 

The cash ratio is even more conservative than the quick ratio It measures the amount of cash & cash equivalents such as shortterm marketable investments to cover current liabilities



Following is the Balance Sheet of X ltd.
Amount Assets Amount 80,000 150,000 130,000 50,000 1,10,000 20,000 40,000 10,000 30,000 150,000 Goodwill 1,30,000 Land and Building 80,000 Machinery 110,000 Long Term Investments 50,000 Stock 35,000 Debtors 25,000 Bills Receivable 10,000 Short Term Investments 15,000 Cash

Liabilities Equity Share Capital 12% Preference Share capital Bank Loan P&L a/c 14% Debentures Sundry Creditors Bills Payable Outstanding Expenses Provision For Taxation

Proposed Dividends

20,000 Prepaid Expenses
625,000

5,000
625,000


1. 2. 3. 4.

Calculate: Net Working Capital Current Ratio Quick Ratio Cash Ratio

Current Assets Stock
Debtors B/R Short Term Investments Cash Prepaid Expenses

Amount
20,000 40,000 10,000 30,000 5,000 215,000

Current Liabilities
Bills Payable Outstanding Expenses Provision for Tax Proposed Dividends

Amount 35,000
25,000 10,000 15,000 20,000 _______ 105000

110,000 Sundry Creditors

1. Net Working Capital= Current Assets – Current Liabilities = 2,15,000-1,05,000 = Rs. 1,10,000

2. Current Ratio= Current Assets/ Current Liabilities = 2,15,000/1,05,000 = 2.05:1 3. Quick Assets= Current Assets- Stock- Prepaid Expenses = 2,15,000- 1,10,000- 5,000 = Rs. 1,00,000 Quick Ratio= Quick Assets/ Current Liabilities = 1,00,000/1,05,000 = 0.95:1 4.Cash Ratio= (Cash+ Short term investments)/ Current Liabilities = (30,000+10,000)/ 1,05,000 = 0.38:1

Measures how well the resources of the company are being utilized.  Measures the rapidity with which the resources like stock, debtors, fixed assets, working capital etc. are being used to produce sales.  Eg- Stock Turnover, Receivable Turnover, Fixed Asset Turnover Ratio


Stock Turnover Ratio= Cost of Goods Sold/ Average stock
Cost of Goods Sold= Opening Stock+ Purchases - Closing Stock Average Stock = (Opening Stock + Closing Stock)/ 2
   

Indicates the efficiency in utilization of stock It shows the number of times the stock is converted into sales during the year Low ratio indicates that stock is lying idle in the godown for long High Ratio indicates the stock is being utilized efficiently



EXAMPLE: Calculate the Stock Turnover Ratio. Trading Account
Amount Particulars Amount 60,000 Sales 1,40,000 1,00,000 Less: Sales Returns40,000 8,000 1,68,000 Cost of goods sold = 60,000 +1,00,000-68,000 = 92,000 Average Stock= (60,000+ 68,000)/2= 64,000 Stock Turnover ratio= 92,000/64,000 =1.44 Times Closing stock 1,00,000 68,000 1,68,000

Particulars Opening Stock Purchases Gross Profit

Debtors Turnover Ratio= Net Credit Sales/ Average Debtors+ Average Bills Receivable (NOTE: use Net Sales if Net Credit Sales is not given)
 

Indicates the speed with which the amount is collected from debtors Higher the ratio, the better since it indicates the collection from debtors are more rapid Lower Debtor turnover ratio indicates inefficient credit sales policy of the management





EXAMPLE: Calculate the Debtor’s Turnover Ratio.
Particulars Total Sales for the Year Amount 1,75,000

Credit Sales @ 60% of total sales
Sales Return out of credit sales Sundry Debtors: Opening Balance Closing Balance

1,05,000
5,000 8,000 12,000

Net Credit Sales= 1,05,000- 5,000= 1,00,000 Average Debtors= 8,000+ 12,000/ 2= 10,000 Debtors Turnover Ratio= 1,00,000/ 10,000= 10 Times

Fixed Asset Turnover Ratio = Revenue/ Net Fixed Assets
Net fixed Assets = Fixed Assets – Depreciation  Ratio indicates how efficiently the fixed assets are being utilized  High asset turnover ratio indicates better utilization of fixed assets

Total Asset Turnover Ratio = Revenue /Average Total Assets
Total Assets = Fixed Assets + Current Assets  Indicates how efficiently the assets are being utilized  High asset turnover ratio indicates that the Company is growing along with the Sales  Companies with high profit margins have low Asset Turnover Ratios & vice versa




Indicates the long term solvency of the firm. Long term lenders are interested to in these ratios to learn how able is the company to make timely interest payments & repay principal. Eg-Debt-Equity Ratio, Interest Coverage Ratio





Debt Equity Ratio= Debt/ Equity OR Debt Equity Ratio= Long term Loans/ Shareholder’s Funds


Long Term Loans: Long-term liabilities which mature after one year like Debentures, Mortgage Loan, Bank Loan, Loan from financial institutions and Public Deposits Shareholder’s funds: Equity share capital, preference share capital, share premium, General reserve, Capital reserve, Other reserves and credit balance of P&L account Ratio indicates the ability of a firm to meet its long term liabilities Debt equity ratio of 2:1 is considered to be safe Higher debt equity ratio shows a risky financial position as it indicates more and more funds invested in the business are provided by long term lenders



  

EXAMPLE: Calculate the debt- equity ratio.
Liabilities
Equity Share Capital Preference Share Capital Reserves P&L a/c Current Liabilities 15% Debentures

Rs
2,00,000 50,000 50,000 60,000 70,000 100,000

Assets
Fixed Assets Current Assets

Rs.
3,80,000 2,20,000

Bank Loan

70,000
6,00,000

_________
6,00,000

Long Term Debt= 1,00,000 + 70,000= 170,000 Shareholder’s Funds= 2,00,000+ 50,000+ 50,000+ 60,000 = 3,60,000 Debt Equity Ratio= 170,000/ 360,000= 0.47:1

Interest Coverage Ratio= NPBIT/ Fixed interest charges


Ratio indicates the no. of times interest charges are covered by the profits to pay interest charges Higher ratio implies greater safety for long term lenders Appropriate interest coverage ratio must be 6-7 times





EXAMPLE: From the Following Data Calculate the Interest Coverage ratio:

Particulars
Net Profit before Interest and Tax 15% Debentures

Amount
3,60,000 2,00,000

Fixed Interest = 2,00,000*15%= 30,000

Interest Coverage Ratio= Rs. 360,000/ 30,000= 12 Times



Profitability Ratios measure the return earned by the company during a period It reflects a company’s competitive position in the market Eg -Return on capital employed, Return on equity, Asset turnover ratio





ROCE= (NPBITD/ Capital employed)*100
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NPBITD= Net profit before interest, tax and dividends Capital Employed= Equity Share Capital + Preference Share Capital + Reserves+ P&L A/C + Debentures



The higher the ratio, the more efficient is the use of capital employed

ROE= (Net Profit after tax, interest and preference dividend/Equity Share Holder’s Funds)*100


Equity Share Holder’s Funds= Equity Share Capital + Preference Share Capital+ Reserves+ P&L A/C ROE is calculated to see the profitability of owner’s investment





Following is the Balance Sheet of X Ltd
Rs 4,00,000 2,00,000 30,000 Assets Fixed Assets Current Assets Rs 8,00,000 3,80,000

Liabilities Equity Share Capital 12% Preference Share Capital Reserves

P&L a/c
15% Debentures Current Liabilities

2,20,000
1,00,000 2,30,000 11,80,000 __________ 11,80,000

Profit for Current Year before interest and tax= Rs. 3,55,000 Tax Rate 50% Calculate: a) ROCE b) Return on Equity Shareholder’s Funds

 a)


SOLUTION: ROCE= (NPBIT/ Capital Employed)*100

Capital Employed= Equity Share Capital + Preference Share Capital + Reserves+ P&L A/c + Debentures Capital Employed = 4,00,000+ 2,00,000+ 30,000+ 220,000+100,000= Rs. 9,50,000 ROCE= (355,000/ 950,000)*100 = 37.37%

b) ROE= NPAT/ Equity Share holder’s funds Calculation of NPAT
Particulars Amount

NPBIT
Less: Interest in Debentures @ 15% on Rs. 100,000 Less: Tax@ 50%

3,55,000
15,000 3,40,000 1,70,000

NPAT
Less: Dividend on Pref. Share Capital @ 12% on Rs. 200,000 Net Profit after interest, tax and preference dividend

1,70,000
24,000 1,46,000

Equity Share Holder’s Funds= Equity Share Capital + Preference Share Capital +Reserves+ P&L a/c = 400,000+ 200,000+30,000+220,000 =Rs. 8,50,000 ROE= (1,46,000/ 8,50,000)*100= 17.18%



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The homogeneity of a company’s operating activities: difficult to find comparable industries The need to use judgment: cannot be used alone Indicator of some aspect of a company’s performance ,telling what happened but not why happened The use of alternative accounting methods: the difference in accounting can distort ratios, and for a meaningful comparison may involve adjustment to the financial data Company size sometimes confers economies of scale, so the absolute amounts of net income and revenue are useful. But, ratios reduce the effect of size to enhance comparison between companies and over time





1)In order to assess a company’s ability to fulfill it’s long-term obligations, you would most likely examine a) Activity ratios b) Liquidity ratios c) Solvency ratios Ans. c

2) Which ratio would a company most likely use to measure its ability to meet short-term obligations a) Interest coverage ratio b) Current ratio c) Debt-to-equity ratio

Ans b

3) In general, a creditor would consider a decrease in which of the following ratios to be positive news a) Interest coverage ratio b) Current ratio c) Debt-to-equity ratio

Ans c

4) Data for XYZ Ltd.(figures in millions of Rs.)

2003
Total debt 1750 Total equity 5000

2004
1900 4500

2005
2000 4000

Select the correct option a) Company is becoming increasingly less solvent b) Company is becoming less liquid c) Company is becoming increasingly more liquid

Ans a

2003: 0.35, 2004: 0.4222, 2005: 0.50( debt to equity ratios)

5) Select the most appropriate cause of increase in debtors turnover of XYZ Ltd. a) The company adopted new credit policies and began offering credit to customers with weak credit histories b) The company had accumulated a substantial amount of uncollectible accounts and wrote off a large amount of its receivables c) Due to competition, the company adopted new payment terms, requiring payment in 30 days rather than previous requirement of 15 days

Ans b

6) Select the most appropriate cause of decrease in inventory turnover of XYZ Ltd. a) The company installed a new inventory management system, allowing more efficient inventory management. b) The company wrote off a large amount of obsolescent inventory c) The company installed a new inventory management system, but experienced some operational difficulties resulting in duplicate orders being placed with suppliers

Ans c

THANK YOU!!

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